What is DepreciationAn asset’s value declines through wear & tear, market conditions, a new model of machinery has been developed in the market with better productivity, etc. This way the organization is able to recover the cost of the asset that will be used for longer period. And write off parts of this expense gradually, without causing a major impact on the profits. Depreciation is simply an expense that can be listed on a tax return for a given reporting period under the applicable tax laws. A very viable expense that is used to reduce the amount of taxable income reported by a business. Depreciation is charging the expense of a fixed asset’s cost, systematically, over its useful life, instead of doing it all in one tax year. The estimated useful life of the asset would help determine the number of years over which it will get depreciated (e.g., a laptop is useful for about five years). For tax purposes, different assets are categorized into different classes, with each class having its own useful life. If you use a different method of depreciation for your four basic financial statements, you can decide on the asset’s useful life as per the expected useful life of the asset in your business. For instance, IRS might require a piece of computer equipment to be depreciated in 5-years, but if you know it will become useless in 3-years itself, you can depreciate the equipment over a shorter time.
What is an AssetAn asset is any property that has a dollar value. It can be tangible or intangible. A tangible asset can be touched, felt and seen—say a building, furniture, vehicle, or computer. An intangible asset is not a physical object—but it can still be bought and sold. Examples are Trademark Registration, Patents, or other such intellectual properties. Depreciation applies to both tangible and intangible assets. For intangible assets, the act of depreciation is called amortization.
The kind of assets you can depreciateIRS has laid down proper guidelines for what types of assets can be depreciated. So, in the United States, depreciation is only treated as a valid expense if the asset meets all of the below conditions. The asset must be:
- a property the business owns
- used in an income-producing activity
- has a determinable useful life
- expected to last over one year
- doesn’t belong to the types of property specifically excluded by the IRS. Say, real estate or land. As their value only increases with time.
- Depreciation as a taxable deduction is only available if the asset is being used for over 50% of the time in your business.
- Real estate
- Office furniture
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What is Depreciation ScheduleThe Depreciation Schedule is a table that displays how much each of the assets will get depreciated over time. It would include the following data:
- Description of the asset
- Date of its purchase
- Its total price
- Expected useful life
- Depreciation method used
- Salvage value–how much that asset will be sold for once it’s past its useful life (e.g., how much a scrapyard would pay for your old vehicle)
Useful Life of AssetsVarious types of property have various periods of time over which they shall be of use and must be depreciated. This is a crucial input data required to calculate the Depreciation of an asset. For example:
- Manufacturing tools and tractors depreciate over a period of 3-years.
- Light vehicles, computers, office equipment, and construction equipment depreciate over a period of 5-years.
- Office furniture and miscellaneous assets are useful for a period of 7-years.
- Residential real estate depreciates over 27.5-years.
- Commercial real estate depreciates over 39-years.
- Renovations to land depreciate over 10, 15, or 20 years, with a few exceptions.
What is an Asset ClassA class is assigned to each general kind of business asset. This classification is based on the expected life of the asset. The expected useful life is different for the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). For instance, the office desk comes under the category of office furniture, Asset Class 00.11, that has a useful life (recovery period) of 7 years under the GDS and 10 years under the ADS. Asset classes for businesses include office furniture, fixtures, and equipment, automated information systems (computers and peripherals), and equipment used in manufacturing different types of products. The complete list of asset classes for a business can be found in IRS Publication 946 (Table B-1), including their useful life, GDS and ADS recovery periods. We have covered the asset class and the recovery period (useful life). Now, let’s check which depreciation system to use.
Types of depreciationThere are several methods of depreciation that can be used to recover the cost of assets in your books or financial statements. Though IRS allows only one method of taking depreciation on your tax return. Therefore, some businesses may use different methods for their books and for taxes, other, small businesses, choose to use the tax method of depreciation for their books, to not complicate things. Let’s check the methods available here:
- Straight-line depreciation: Thisis the simplest method, but immediate gratification is limited. The largest deductions, usually, come in later years. New businesses and start-ups which expect to be much more profitable in later years mostly prefer this method, deferring the larger deductions to a later time when they’ll, expectedly, have more income to offset the deduction.
- Accelerated Depreciation: The majority of deduction takes place in the initial years and the depreciation in later years is much smaller. This is a good option for businesses experiencing a banner year and needing as many deductions as possible in the current year as possible.
- Section 179 allows businesses to take a deduction for the entire value of the property or asset in the first year itself. To take this advantage, the equipment must be purchased and put into service/installed by midnight 12/31/2020. The full deduction can be claimed until the $2,590,000 equipment purchase limit is reached. Later, the deduction decreases on a dollar for dollar basis, and reaches zero once $3,630,000 worth of equipment has been purchased. This makes a very attractive tax deduction for small and medium businesses, who won’t, typically, hit $2,590,000 in purchases in any given year. This limit was effectively doubled, by the Tax Cuts and Jobs Act (TCJA), from what it was in 2017, and it provides that it be adjusted periodically for inflation.
What is the Depreciation Systems under IRSIRS requires the Modified Accelerated Cost Recovery System (MACRS) of depreciation to be used for assets purchased and used after 1986. There are a few exceptions that have been elaborated in IRS Publication 946. MACRS, or Modified Accelerated Cost Recovery System, is currently the method, approved by IRS, for companies wanting to accelerate depreciation on business equipment. MACRS includes an asset classification system (mentioned above) showing the number of years of depreciation for each type of asset. MACRS includes two depreciation methods, the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). These two methods provide different calculations and recovery periods for determining depreciation deductions. Generally, GDS is used by most businesses unless they are required to use the ADS. The GDS uses the “declining balance” system of calculating depreciation. Under this, the depreciation expense each year is based on the initial cost reduced by accumulated depreciation from all previous years. For example, if the initial cost of some office furniture is $1000 and the first-year depreciation is $143 (using the 7-year useful period), the balance at the end of the first year is $857. So, in the second year, the depreciation would be calculated on $857, and the second year depreciation expense comes to be $122 (using the 7-year period again).
How is Alternative Depreciation calculatedUnder the ADS system, depreciation is set at an equal amount each year, except for the first and last year (when they might not be a full 12-months). As explained above, this method results in more years of depreciation, lowering the amount of depreciation cost each year. The ADS system can be used for all assets in a specific class, but real estate must be depreciated on a property-by-property basis. Once you have chosen the ADS for an asset, you can’t return to the GDS.
Benefits of using the Alternative Depreciation SystemADS would prove to be useful in the following circumstances, for instance:
- Listed property used 50% or less for business operations
- Tangible property used essentially outside the U.S. during the year
- Farming equipment, under specific circumstances
- Certain tax-exempt property.
IRS Section 1250Section 1250 is only applicable if, at first, you depreciate the value of a rental property using an accelerated method, and then sell the property at a profit. Without Section 1250, people could buy property, quickly write off part of it, and then sell it for a profit without giving the government its fair share. Section 1250 helps protect against this kind of tax evasion. But if you use an accelerated depreciation method, and then sell the property at a profit, the IRS makes an adjustment. They take the amount that was written off using the accelerated depreciation method, compare it with one derived at using the straight-line method, and approach the difference as taxable income. In other words, your tax bill would get increased in the year of sale. Finally, if you’re buying rental property and plan to sell it within a few years, you should consult your tax advisor or bookkeeping services before making any big decisions.
ConclusionDepreciation is a complicated process, not a DIY subject. Tax laws change frequently, so you should consult a tax professional for the most updated advice. This article is only intended to give you a general understanding. Check with your professional tax advisor for information on which depreciation system you should use to maximize the tax benefits for your business. At AutoFilings, we strive to advise you for the maximum tax deductions that your business can and should take. Our customized services would keep your expenses at their lowest and benefits at their highest.
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Frequently Asked Questions
How to compute depreciation on my capital assets?
You need below information to compute depreciation: 1. Basis 2. Class Life 3. Placed in Service 4. Method of Depreciation
What is Basis?
Basis is the original cost of your asset, including sales tax, freight, and installation expenses. The cost of the property includes: 1. Cash 2. The money borrowed to purchase the asset 3. The value of any items traded to purchase the new asset 4. The value of bartered services The Basis will increase by any major improvements you make to the property and will decrease by the amount of depreciation deductions taken on that asset in your tax return. This adjusted Basis shall be used to evaluate your gain or loss when you sell the property.
What is Class Life?
Class Life is the period over which an asset can be depreciated. The tax law has categorized specific class life for each type of asset. For instance, real estate is 39-year property, office furniture is 7-year property and autos & trucks are 5-year property.
Why is the term “placed in service” important?
Property is placed in service when it is ready and available for use in your business even if the actual usage has not yet started. This determines the date when you can begin to depreciate the asset.
What method of depreciation should I use?
The method used by most taxpayers is the MACRS (Modified Accelerated Cost Recovery System). It provides a uniform method for all taxpayers to compute the depreciation. Using the basis, class life, and the MACRS tables, the deduction can be calculated for each asset in the year it is placed in service and each subsequent year of its class life.
Is there any exception to the rule that all costs of property must be depreciated?
This exception comes under Section 179 Deductions. You can opt to take an immediate deduction for some personal property that would otherwise be depreciated over several years. This election must be taken in the year when the property was placed in service. This special deduction cannot be taken on the asset you’ve previously used personally and then converted to business use. This deduction is limited to your net business income & wages. A maximum dollar limit, changing every year, also applies. If you were not able to use all of the Section 179 Deductions because of the income limit, the unused deduction can be carried over to the next tax year.
Are there any limitations on the amount of depreciation that can be claimed in one year?
No overall limitations on yearly depreciation. However, if an asset comes under the Listed Property, your annual deduction is limited. Listed property is those business assets that are often used for personal purposes. And, under the MACRS rules, their depreciation is restricted. The listed property includes: 1. Vehicles weighing 6,000-pounds or less 2. Other property used for transportation (pick-ups, buses, motorcycles, boats, airplanes, etc.) 3. Property used for entertainment, recreation, or amusement (photographic equipment, video recorders, stereo equipment, etc.) 4. Computer and peripherals unless used at a regular place of business 5. Cellular telephones
How to claim depreciation on my tax return?
Complete and attach Form 4562 to your tax return if you are claiming any of the below: 1. Section 179 deduction for the current year or a carryover Section 179 deduction from a previous year 2. Depreciation for property placed in service during the current year 3. Depreciation on any vehicle or other listed property, regardless of when it was placed in service
Can I depreciate the cost of land?
Land can never be depreciated. Since land cannot be depreciated, the original purchase price needs to be allocated between land and building. The property tax assessor’s values can be used to compute a ratio of the value of the land to the building.