About Depreciation

This topic describes depreciation. The traditional approach to depreciation is based upon the fact that when a taxpayer buys a business or an investment-related asset that wears out, he or she can spread the costs over the period of the asset's useful life rather than entirely at the point at which the cost was incurred.

Depreciation Rules Prior to ERTA

Prior to ERTA (1981), the depreciation rules allocated the cost of an asset that has a limited life over appropriate accounting periods in order to determine the taxable income during each of these periods. In theory, the depreciation deduction equaled the amount of the asset that was "used up" during the annual period. This depreciation deduction permitted the taxpayer to recoup annually a portion of the cost of these depreciable assets.

The factors that influenced the depreciation amount were the estimated useful life of the asset and the method of depreciation used. This depreciation system was based upon the assumption (sometimes fictional) that the asset would be economically productive only for a reasonable period of time and at the end of that time there would be a small "salvage value."

Estimation of an asset's useful life was based upon the particular facts and circumstances of the anticipated use. This estimation created numerous controversies and administrative problems. Taxpayers generally wanted the shortest possible useful life in order to increase deductions against ordinary income. However, the tax service often felt that the "useful life" was much greater than that estimated by the taxpayers.

Over the years, the IRS prepared and disseminated various guidelines to estimate useful lives. The Asset Depreciation Range System (ADRS) presented guidelines for the depreciable lives of specified classes of assets grouped by industrial classifications and by certain broad general asset classifications.

A taxpayer electing to use the ADRS system could rely on the lives set forth therein as being safe from challenge by the IRS. With regard to assets not covered by ADRS, the depreciation period (useful life) was based upon actual facts and circumstances of each asset. However, this was subject to attack by Internal Revenue in each specific case.

Depreciation methods were generally grouped into two categories:

Straight Line: The taxpayer's depreciation deductions are spaced equally over an asset's useful life.
Accelerated Depreciation Method: Includes Declining Balance Method, Double Declining Balance Method, Sum Of The year's digits, ACRS, MACRS, and other sophisticated methods.

The purpose of providing for Accelerated Depreciation was twofold:

To stimulate capital investment
To encourage risk-taking investment

The accelerated methods permitted taxpayers to allot larger depreciation deductions to the earlier years of an asset's life and smaller deductions to later years.

The purpose of accelerating deductions in early years is to allow the taxpayer to pay less in taxes during the earlier years of an asset's useful life. The taxpayer thereby gains the benefit of deferring his or her tax obligation to a later time. The taxpayer will be able to earn money on the amounts which would otherwise have paid taxes in the early years of the asset depreciation schedule.

Accelerated Cost Recovery Systems

In general, the Accelerated Cost Recovery Systems established by ERTA provided for an accelerated recovery of the cost of tangible, depreciable property used in a trade or business or held for the production of income and placed in service after 1980, but prior to 1987. The cost is recovered over a period of 3, 5, 10 and 15 years. ACRS defined easily identifiable classes of assets and prescribed standard cost recovery periods for these classes. It divorced the capital recovery period from the concept of "useful life." After ACRS, the terms Asset Depreciation Range and "useful life" generally no longer apply.

For personal property, taxpayers have the option to use the Straight Line method over the regular recovery. For real property taxpayers have the option to use the Straight Line method over the recovery methods described in Code Sections 167 and 168.

Modified ACRS (MACRS) was introduced in 1986 and provides recovery periods of 3--5--7--10--15--17.5--20 and 31.5 years. Basically, MACRS took away some of the advantages to the taxpayer included in the more rapid ACRS recovery. Technically, ACRS and MACRS are not depreciation methods because they are not based upon a "useful life" of property. The deduction is based upon an allowed method of cost recovery to the taxpayer. However, they are nevertheless referred to as depreciation methods.

ACRS was designed to spur capital investment and to help businesses to recover their costs faster and thereby keep pace with the rate of inflation which was excessive in 1980 and previous years. This system was also designed to reduce disputes between taxpayers and the IRS over the useful life of assets. MACRS was a step backward from the standpoint of taxpayers. However, it appears preferable to the systems of recovery in use prior to 1980.

As property is depreciated and tax deductions permitted during the depreciation, the basis of the property being depreciated changes. Upon a sale or other disposition of the property, the amount of gain for which the taxpayer is taxed is the excess of the amount realized upon transfer over the adjusted basis of the property disposed of whether by sales, exchanges, or involuntary conversions.

Deductions are allowed only for business property or property held for the purpose of producing income. Such property does not include inventory nor unimproved real estate.

Goodwill cannot be depreciated, because no useful life can be attributed to it. Therefore, in business transactions, what would be classified as goodwill is often treated as a covenant by the Seller not to compete. Covenants not to compete can be depreciated on a Straight Line basis over the term of the covenant.

Remember that without depreciation you would, for example, pay $1,000 for a piece of machinery and not have any tax break whatsoever. If you held the property for five years and sold it for $800, there would be no tax. If you sold it for $1,200, there would be a tax on the $200 gain. Depreciation allows you a tax advantage in the years of depreciation, however, if you later sell or dispose of the property, this tax advantage is recaptured as taxable income. For example, if the $1,000 piece of machinery is depreciated under MACRS for three years, there would be an adjustment to basis for the amount allowed during each of those years as a deduction. Assuming the property is in the five year class, the MACRS deductions would be $200 for the first year, $320 for the second year, and $192 for the third year. The adjusted basis after the three years would be $288. If, at the end of the three years, the taxpayer sold the item of equipment for $900, he would have a taxable gain on the difference between the depreciated basis and the sale price.

Obviously, if the taxpayer is in a high tax bracket, he will derive greatest benefit by using the most rapid recovery method possible. If, on the other hand, the taxpayer's marginal tax rate is low, the election of a Straight Line method of depreciation and an extended recovery period could prove more advantageous, particularly if income is expected to increase in later years.

The Treasury Department is constantly changing regulations relative to depreciation either to spur the economy or increase revenue.

Partial Depreciation

You can schedule a partial year depreciation when an asset is placed in service at some time during the calendar or fiscal year.

For more information, see About Partial Depreciation.