Depreciation Concepts and Methods Explained
What is Depreciation?
When you buy a capital asset, such as a service station, you expect to use that item for several years. A capital asset is a piece of equipment, a building, or a vehicle for use in your business. The cost of these capital assets should be written off over the same period of time you expect them to earn income for you. Therefore, you must spread the cost over several tax years and deduct part of it each year as a business expense. As these assets wear out, lose value, or become obsolete, you recover your cost as a business expense. This method of deducting the cost of business property is called depreciation .
There are two types of property that can be depreciated:
Real Property – Buildings (real estate) or anything else built on or attached to land. Land can never be depreciated.
Personal Property – Cars, trucks, equipment, furniture, or almost anything that isn’t real property.
What Can Be Depreciated?
You can depreciate property if it meets all the following requirements:
It must be used in business or held to produce income.
It must be expected to last more than one year.
It must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
What Cannot Be Depreciated?
Property placed in service and disposed of in the same year.
Repairs and replacements that do not increase the value of your property, make it more useful, or lengthen its useful life.
When Depreciation Begins and Ends
You begin to depreciate your property:
When you place it in service for use in your trade or business.
When it is used for the production of income.
You stop depreciating property either:
When you have fully recovered your cost or other basis.
When you retire it from service, whichever happens first.
For depreciation purposes, you place property in service when it is ready and available for a specific use, whether in a trade or business, the production of income, a tax-exempt activity, or a personal activity.
You bought a home and used it as your personal home several years before you converted it to rental property. Although its specific use was personal and no depreciation was allowable, you placed the home in service when you began using it as your home. You can claim a depreciation deduction in the year that you converted it to rental property because its use changed to an income-producing use at that time.
You bought a folding machine for your business late in the year. You take a depreciation deduction for the machine for that year because it was ready and available for its specific use.
How To Claim Depreciation
In order to claim depreciation you must complete and attach Form 4562, Depreciation and Amortization to your tax return if you are claiming any of the following.
A section 179 deduction for the current year or a section 179 carryover from a prior year.
Depreciation for property placed in service during the current year.
Depreciation on any vehicle or other listed property, regardless of when it was placed in service.
A deduction for any vehicle if the deduction is reported on a form other than Schedule C (Form 1040), Profit or Loss FromBusiness, or Schedule C-EZ (Form 1040), Net Profit Sales less direct costs less overhead equals profit before taxes. The amount left over after all the revenues for a period is accounted for, and all costs and expenses for the same period are deducted. Profit is also called net profit, income, or net income. From Business.
Amortization of costs that began in the current year.
Any depreciation on a corporate income tax return (other than Form 1120S, U.S. Income Tax Return for an S Corporation).
Depreciation Methods Explanation
This section helps explain the various depreciation methods used by Total Office Manager. If you have questions about depreciation, please contact your company’s own accountant or CPA.
MACRS (Modified Accelerated Cost Recovery System)
The government’s system for computing depreciation on capital equipment. This is THE allowed method for recently purchased assets.
The number of periods over which you will depreciate an asset. This may or may not correspond to the useful life. MACRS provides a table for you to use to look up recovery period. You will depreciate the asset from periods 1 through recovery period + 1. This is due to (see next item).
Half Year Convention
MACRS assumes that you buy the asset half way through the year. Therefore, in the first year, you really only get one half years worth of depreciation. In year recovery period + 1 you get the half year back.
Mid-Month Convention for Real Estate
Real estate is more precise. If you buy something in a particular month j (January = 1, December = 12), then for the first year, you get 12 – j +.5 months of depreciation allowance. If you sell in month j (and before the recovery period is over), then you get j – 0.5 months of depreciation in the year when you sell.
The item will never be depreciated or amortized. This typically includes equipment with a purchase price of less than $300.00.
This item is fully depreciated during the first year of service. Under current tax law, this often occurs under Section 179 of the tax code . Note: Section 179 has limits and they vary by tax year.
A method of calculating the depreciation of an asset which assumes the asset will lose an equal amount of value each year.
Accelerated Cost Recovery System. ACRS generally applies to all assets placed in service from 1981 through the end of 1986. The salvage value of an asset is not taken into consideration. Based on 3, 5, 10, 15, 18, and 19 year lifetimes only.
Modified Accelerated Cost Recovery System. This method is similar to the 150% declining balance method, but it switches to the straight line rate when those would be higher than the Declining Balance rate.
Modified Accelerated Cost Recovery System. This method is similar to the 200% declining balance method, but it switches to the straight line rate when those would be higher than the Declining Balance rate.
150% Declining Balance
This method uses 150% of the straight-line percentage for the first year. The same percentage is then applied to the remaining balance each succeeding year.
200% Declining Balance
This method uses 200% of the straight-line percentage for the first year. The same percentage is then applied to the remaining balance each succeeding year. This method is often referred to as the Double Declining Balance Method, or DDB.
MACRS is the government’s deal with businesses for depreciating assets. The idea here is to develop a fair standard system that everybody can use easily.
MACRS uses two conventions. All assets are assumed to enter service halfway through the first year and to leave service halfway through the last year. This is called the half-year convention.
The depreciation method changes from an accelerated method to the straight-line method in the year where the straight-line depreciation begins to exceed the accelerated depreciation.
Salvage value is not deducted from the cost of an asset when computing depreciation under the MACRS system.
Although depreciation is not a cash flow, it does have an impact on income taxes. Depreciation deductions shield revenues from taxation (called a depreciation tax shield) and thereby reduce tax payments.
Section 179 of the Internal Revenue Code allows a trade or business to take a full write-off on certain tangible personal property in the year it puts the furnishings or equipment into use. These items can range from a desk to a laptop.