Tax depreciation can be a complicated topic, particularly in the current environment. It is more important than ever, though, for companies to recover the costs that they have invested in their assets.
Here are some common phrases and vernacular surrounding tax depreciation, along with key items for consideration when calculating tax depreciation.
What is Tax Depreciation?
Tax Depreciation is the systematic allowance for the wear and tear of certain types of property (Depreciable Property) used in a trade, business, or held for the production of income (Code Sec. 167(a)). Tax Depreciation takes the capitalized portion of an asset’s cost (Depreciable Basis) and deducts the amount as an expense over the useful life of the asset. The purpose of the allocation is to try and match the expense with the income production from the depreciable asset over its useful life.
How to Determine Depreciable Property
Depreciable property is an asset that meets all three of the following criteria:
- Is used for business or is held for the production of income
- Has a useful life > 1 year
- Wears out, breaks down, becomes obsolete from natural causes
Depreciation does not apply to any of the following:
- Land (Apart from any land improvements to it)
How to Calculate Depreciable Basis
Holding all things constant, depreciable basis is the total amount of depreciation that will be taken over the asset’s useful life. As an example:
+ Sales Tax
+ Transaction Costs (Reg. §1.263(a)-2(f))
= Depreciable Basis
Determining Useful Life Through MACRS
Under the Modified Accelerated Cost Recovery System (MACRS), there are 2 depreciation systems, General Depreciation System (GDS) & Alternative Depreciation System (ADS), which each assign their own useful life to a class of assets. Each piece of property is assigned to an asset class, which drives the assignment of an asset’s class life.
Class lives are assigned under Rev. Proc. 87-56, 1987-2 C. B 674. This revenue procedure breaks up the assignment of life into two categories:
- Asset Classes 00.11 – 00.4 (Asset Category)
- Asset Classes 01.1 – 80.0 (Activity Category)
Depreciable property can be described in both an asset category as well as an activity category. In such cases, the asset category should be used for life assignment unless the asset is specifically included in the activity category.
Placed in Service Date
Depreciable property is deemed to be placed in service when it is in a state or condition to be used for its assigned purpose. This makes it possible for a piece of property to be placed into service prior to the actual use of such property. Depreciation may not be calculated until the tax year that the property is placed into service.
Methods of Tax Depreciation
There are two different depreciation systems under MACRS, which each have their own depreciation methods. Under the General Depreciation system, there are three depreciation methods: 200 Percent Declining Balance, 150 Percent Declining Balance, and the Straight-Line Method.
200 Percent Declining Balance Method is used to depreciate property with lives of 3,5,7,10 years. Generally, the 150 Percent Declining Balance Method is used to depreciate property with lives of 15 & 20 years. There is an irrevocable election for a taxpayer to use the 150 Percent Declining Balance Method for 3,5,7,10 year property. This election applies to the property class (E.g., all 3-year property). The Straight-Line method is mandatory for certain types of assets, namely residential rental property and nonresidential real property. Additionally, there is a Straight-Line irrevocable election for 3,5,7,10,15, & 20 year property. This election applies to the property class as a whole.
Under the Alternative Depreciation System, the depreciation method used is the Straight-Line Method. This differs from the GDS Straight-Line method because ADS lives are used, which generally requires longer recovery periods.
How to Use Averaging Convention
An averaging convention is used to calculate MACRS deductions in the tax year the property was placed into service and in the year of disposition. There are three averaging conventions: Half Year, Mid-Month, & Mid-Quarter.
Under the Half Year Convention, the recovery period for the depreciable property is deemed to begin & end during the midpoint of the tax year. Generally, this convention applies to all property other than residential rental property and nonresidential real property.
Under the Mid-Month Convention, the recovery period for the depreciable property is deemed to begin and end during the midpoint of the month. Generally, this convention applies to residential rental property and nonresidential real property.
Under the Mid-Quarter Convention, the recovery period for the depreciable property is deemed to begin and end during the midpoint of the quarter the asset was placed into service. For the mid-quarter convention to apply, more than 40% of the property placed into service during the tax year must have been placed into service in the 4th quarter. If the threshold is met, it applies to all assets placed into service for that specific tax year. The convention does not apply to residential rental property or nonresidential real property.
Tax Forms for Tax Depreciation
The two most common tax forms for tax depreciation are Form 4562 & Form 4797.
Form 4562 is used to report the following:
- Depreciation/amortization for assets placed in service in the current year
- Any 179 expense deduction
- Any bonus depreciation taken in the current year
- Current year depreciation/amortization for assets placed in service in prior years
Form 4797 is used to report the following:
- Gain/loss from property dispositions held more than 1 year
- Gain/loss from property dispositions held less than 1 year (Ordinary Loss)
In addition to these common forms, other forms that may be used for tax depreciation purposes include:
- Form 3115: Accounting Method Changes
- Form 8824: Like Kind Exchanges
Tax depreciation can be a complicated ever-changing topic, but grasping the basic concepts listed above can help navigate any challenges you may face. To learn more about GTM’s tax depreciation services or to speak with someone who can guide you through the process, visit us here.