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Depreciation Methods Are Constrained by Legal Requirements

Filed under Federal Taxes. Fact checked on February 14, 2014.

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You must deduct the cost of a capital asset used in your business using depreciation methods and schedules dictated by the IRS. Most assets acquired after 1986 must be depreciated using MACRS, but other methods may be allowed.

Theoretically, the cost of an asset should be deducted over the number of years that the asset will be used, according to the actual drop in value that the asset will suffer each year. At the end of each year, you could subtract all depreciation claimed to date from the cost of the asset, to arrive at the asset's "book value," which would be equal to its market value. At the end of the asset's useful life for the business, any value remaining would represent the salvage value for which the asset could be sold or scrapped.

Since computing the actual drop in value of each business asset would be difficult and time-consuming (if, indeed, it was possible at all), accountants use a variety of conventions to approximate and standardize the depreciation process. Most of the methods currently used involve "front-loading" the amount deducted in the first years of the properties life, rather than in equal amounts over the life of the asset.

For example, the straight-line method assumes that the asset depreciates by an equal percentage of its original value for each year that it's used. In contrast, the declining balance method assumes that the asset depreciates more in the earlier years. 

The following table compares the depreciation amounts that would be available under these two methods, for a $1,000 asset that's expected to be used for five years and then sold for $100 in scrap.

  Straight-Line Method Declining-Balance Method
Year Annual Depreciation Year-End Book Value Annual Depreciation Year-End Book Value
1 $900 x 20%=$180 $1,000-$180=$820 $1,000 x 40%=$400 $1,000-$400=$600
2 $900 x 20%=$180 $820-$180=$640 $600 x 40%=$240 $600-$240=$360
3 $900 x 20%=$180 $640-$180=$460 $360 x 40%=$144 $360-144=$216
4 $900 x 20%=$180 $460-$180=$280 $216 x 40%=$86.40 $216-$86.40=$129.60
5 $900 x 20%=$180 $280-$180=$100 $129.60 x 40%=$51.84 $129.60-$51.84=$77.76

As you can see, the straight-line method provides the same deduction amount every year, while the declining-balance method provides much larger deductions in the first years and much smaller deductions in the last two years. In one regard, this is a plus for the business owner because the upfront costs of the asset are recouped more quickly. 

However, the downside of this system is that if the equipment is expected to be sold for a higher value at some point in the middle of its life, the declining balance method can result in a greater taxable gain that year because the book value of the asset will be relatively lower.

Warning

Make sure you claim your depreciation. Most people realize that if they claim more depreciation than they're entitled to, they may suffer penalties in a tax audit. 

What many people don't know is that depreciation is not optional. 

If you don't claim all the depreciation deductions that you're entitled to, you will be treated as having claimed them when it comes time to compute your taxable gain or loss on the sale or disposal of the asset. This means you'll have more gain to report, but you will have lost out on the deductions from your income over the years.

You Must Use A Permissible Method

The depreciation method that you use for any particular asset is fixed at the time you first place that asset into service. Whatever rules or tables are in effect for that year must be followed as long as you own the property. Since Congress has changed the depreciation rules many times over the years, you may have to use a number of different depreciation methods if you've owned business property for a long time.

In some cases, the IRS gives you a choice between two or more different methods, but you must choose one of them. You can't create your own system. For example, you can't choose to depreciate your computer over three years, when the IRS mandates a five-year period, even though you may know your particular computer will be obsolete and replaced within three years.

Changing Your Depreciation Method

If you make a mistake and claim the wrong depreciation amount, you generally can file an amended tax return (Form 1040X) for the year at issue and correct your deduction. However, if you make the same mistake for two or more consecutive tax years and the mistake is not a simple math error (for example, you realize that you've been using the wrong table), you've effectively chosen an accounting method, and you cannot correct the mistake by filing an amended return. Instead, you must file IRS Form 3115, Application for Change in Accounting Method, requesting permission to change accounting methods.

When Does Depreciation Begin?

Your depreciation deductions for an asset begin in the tax year in which you "place it in service." However, the amount you can claim in the first year depends upon the type of property and what percentage of property was placed into service in the last quarter of the year. Depreciation ends when the property is fully depreciated or you dispose of it, whichever happens first.

Depreciation Begins When Asset is Placed in Service

Just buying a depreciable asset doesn't automatically entitle you to claim depreciation on it. In order to claim a depreciation deduction for the property in a given year, you must put it to productive use in the business before the end of the tax year.

For any depreciation using the MACRS system (and this is nearly all depreciation,) the amount of depreciation you can claim in the first year depends upon:

  • the date on which you place the property in service,
  • the type of property, and
  • the total amount of property that you placed in service during the year.

If you sell or dispose of the property within the year you got it, you can't claim a depreciation deduction at all. Note that, if you elect to expense the cost of the asset or if you claim bonus depreciation on it, when you place the property in service doesn't matter as much. As long as you begin using the property before the end of the year, you get the entire deduction.

Nonresidential Real Estate Uses Mid-month Convention

Nonresidential real estate (a classification that includes home offices and residential rental property) must be depreciated using a mid-month convention. That is, your property is treated as being placed in service in the middle of the month in which you actually placed it in service. You will get a deduction for half of that month, plus the rest of the months for the remainder of the year. This principle, known as the mid-month convention, is factored into the depreciation tables use for this type of property.

Most Property Uses Half-year Convention

For most depreciable property other than real estate, a half-year convention must be used. This means that no matter what month of the year you begin using the property, you must treat it as if you began its use in the middle of the year. So, you will generally get one-half of the first year's depreciation, regardless of when you placed the property in service. Again, this principle is factored into the depreciation tables used for most depreciable property.

Late Year Purchases May Trigger Mid-quarter Convention

However, there's an important exception to the half-year convention described above. If Uncle Sam were going to give you a half year's tax break for a purchase made any time in the year, what would keep you from routinely purchasing all your business assets and placing them in use in the final days of December? Presumably, that would allow you to get a deduction for a half year's worth of depreciation, while avoiding any actual cash outlay until late in the year. Good deal? You bet! Unfortunately, the IRS is well aware of this strategy, and has imposed the rules to prevent you from doing that.

The mid-quarter convention rules, apply if you place more than 40 percent of your total new, depreciable (MACRS) property for the year into service in the last quarter. If you do, you will have to use these rules for all assets placed in service during the year. 

Under the mid-quarter rules, assets are considered to be placed in service at the midpoint of the quarter in which they were actually placed in service. So, for the first year, depending on the quarter in which you placed the asset in service, you would get the following portions of a full year's depreciation:

Mid-quarter Percentages
First Quarter 87.5%
Second Quarter 62.5%
Third Quarter 37.5%
Fourth Quarter 12.5%

Don't worry about having to work with these percentages to calculate your deduction; they are factored into the depreciation charts the IRS provides for mid-quarter property.

To avoid the mid-quarter rules, don't be too aggressive about placing a lot of property in service late in the year. However, there may be times when using the mid-quarter convention can work to your advantage. If you place a large, expensive asset in service in the first quarter, you may be able to claim more depreciation by placing slightly more than 40 percent of new assets in service in the last quarter.

Example

If you placed five-year assets with a total value of $10,000 in service at various points during the year, but no more than $4,000 in assets were placed in service in the fourth quarter, you'd ordinarily be able to claim a total of $1,000 ($10,000 x .20 (i.e. 20 percent of 5 years) x .50 (i.e. 50 percent due to the half-year convention) in the first year under the half-year convention and using the straight line depreciation method.

With a slight change in the time assets are placed in service, the outcome changes under the midquarter convention. If $5,999 in assets were placed in service in the first quarter and $4,001 in the fourth quarter, over 40 percent of the assets would be placed in service in the fourth quarter. The first year depreciation deduction would be as follows:

Item 1: $5,999 x .20 x .875 = $1,049.83

Item 2: $4,001 x .20 x .125 = $ 100.03

Total first year depreciation: $1,149.86

How Long Are Assets Depreciated?

Depreciation ends when you dispose of an asset or you reach the end of the asset's recovery period. Regardless of the depreciation method that you use, you must stop claiming depreciation when the cumulative depreciation you've claimed over the years is equal to your original cost or other basis in the property, or when you stop using the asset in your business.

Warning

One of the more common mistakes business owners make is to continue depreciating property beyond the end of its recovery period.

This is not permitted, except in the case of "luxury cars" where the dollar limits prevented you from claiming the full depreciation amounts within six years after the car's purchase.

Depreciation in the year of disposal. If you sold, scrapped, or otherwise disposed of an asset during the year, you can claim a depreciation deduction for the year of disposal, based on the depreciation convention you used.

If you were using the usual MACRS method, which includes a half-year convention, you're treated as owning the asset for half of the final year. If you were using the mid-month or mid-quarter convention, you're treated as owning the asset until mid-way through the month or quarter in which you stopped using it.

MACRS Required for Most Property

For most business property placed in service after 1986, you must depreciate the asset using a method called the Modified Accelerated Cost Recovery Method (MACRS).

Think Ahead

Depreciation kicks in with regard to the basis in the property after the expensing election and/or "bonus depreciation" is claimed in the first year the property is placed in service. So, if you claimed the 100 percent bonus depreciation that was available in 2011, you will not have any depreciation to deduct in future years. The same result occurred if you elected to expense the entire cost of the item.

Although the prospect of writing off the entire cost of an asset in the first year is enticing, it is wise to consider two long-term factors:

  1. Will your business income increase, making depreciation deductions desirable in the future?

  2. Are you going to be able to take the tax hit if you have to sell the item and recapture all of that front-loaded depreciation?

Your tax adviser can help you run through various scenarios, as can some tax preparation programs.

MACRS assigns each type of business asset a "class" and specifies the time period over which you can write off assets in each class. The most commonly used items are classified as shown in the chart that follows.

Class of Property Items Included
3-year property Tractor units; racehorses over two years old placed in service after 2013; racehorses of any age place in service after 2008 but before 2014; horses over 12 years old when placed in service; any assets used in hog breeding.
5-year property Automobiles; taxis; buses; trucks; computers and peripheral equipment; office machinery (faxes, copiers, calculators etc.); any property used in research and experimentation. Also includes breeding and dairy cattle, goats and sheep.
7-year property Office furniture and fixtures; grain storage assets; and any property that has not been designated as belonging to another class.
10-year property Single-purpose agricultural or horticultural structures, and trees or vines bearing fruit or nuts; assets used in printing.
15-year property Depreciable improvements to land such as shrubbery, fences, roads, and bridges.
20-year property Vessels, barges, tugs, similar water transportation equipment; farm buildings that are not agricultural or horticultural structures.
27.5-year property Residential rental property.
39-year property Nonresidential real estate, including home offices. (Note: the value of land may not be depreciated.)

Not All Assets Are Eligible for MACRS

Some assets are not eligible for MACRS depreciation. Intangible assets such as patents, trademarks, and business goodwill are not depreciated. Instead, this type of asset generally must be amortized (written off in equal amounts) over a 15-year period, beginning in the month of acquisition. Off-the-shelf computer software must be amortized over 36 months.

Depreciation Tables Are Used to Determine Deduction

Once you know the asset's classification and the tax basis of the asset, you can use tables provided by the IRS to determine the percentage of the item's tax basis that can be deducted each year. MACRS provides for a slightly larger write-off in the earlier years of the cost recovery period. The full set of depreciation tables showing the MACRS percentages are available in the IRS's free Publication 946How to Depreciate Property, available on the Internet at

As an example, the following chart shows the depreciation amounts under MACRS for office furniture (7 year property) purchased in  for $10,000. The amounts in the third column are taken from the MACRS half-year convention table, which is the one most commonly used. Notice that the asset's tax basis does not change over the years; only the percentage used as a multiplier changes each year.

Year Basis Percentage Deduction
2012 $10,000 14.29% $1,429
2013 $10,000 24.49% $2,449
2014 $10,000 17.49% $1,749
2015 $10,000 12.49% $1,249
2016 $10,000 8.93% $893
2017 $10,000 8.92% $892
2018 $10,000 8.93% $893
2019 $10,000 4.46% $446

If you do not use the asset 100 percent for business, then each year you must multiply the asset's total tax basis by the business percentage for that year, and then multiply the result by the fraction found in the table.

Example

 If, you use the office furniture from the previous example only 50 percent for your business, you would multiply the $10,000 tax basis by .50, and then multiply the result by .2449 to get your final depreciation figure.

Some special variations of MACRS, as well as other depreciation methods, are available (or even mandatory) in certain situations.

  • Assets of similar types may be grouped into general asset accounts.
  • Variations on MACRS are available, for those who desire slower depreciation. They are mandatory for farm property and for 15- and 20-year property.
  • Straight-line depreciation is also available, and is mandatory for some alternative minimum tax purposes
  • Older methods of depreciation are used for pre-1987 property.

Asset Groups Simplify Recordkeeping

To simplify depreciation recordkeeping and reporting, you can combine similar assets into groups, provided you follow the IRS's rules. You can create a "general asset account" if you place more than one asset of the same type into service during the year, and the assets are

  • in the same class, with the same recovery period, and
  • use the same depreciation method.
  • used 100 percent for using in the first year you place them in service.

For example, if you purchase five computers to use in your business in Year A, you can create a general asset account for them. However, if you purchase four computers and a desk, you cannot include the desk in the asset group with the computers because the recovery periods are different.

If you place assets into a general asset group, you will treat all the assets in the group as a single asset for depreciation purposes.

Warning

Although the general asset account can simplify your recordkeeping, it can also cause problems if you sell one, but not all, of the assets in the group before the end of the recovery period.

In that case you might have to recognize the full amount of the sales price as ordinary income (not the sales price minus the tax basis of the item, as in the usual case). You would continue to depreciate the entire group of assets for the remainder of the class life, including the asset you've already sold.

Be sure to check with your tax adviser if you think you want to use a general asset account.

Real Estate and Other Assets Use MACRS Variations

The normal MACRS depreciation tables are the most commonly used and generally the most favorable to taxpayers, because they provide for the largest possible deductions in the earliest years. However, you do have the option of using slower depreciation methods.

150-percent declining balance. While normal MACRS uses a 200 percent declining balance method for 3-, 5-, 7- and 10- year property, there is also a 150 percent declining balance method that is available as an option for most business owners, and that must be used for all farm property, and for all non-farm property in the 15- and 20-year property classes.

Most often the 150 percent declining balance method is used for the same recovery periods as normal MACRS, but you do have the option of using the longer ADS recovery periods as described below.

Normal MACRS uses a straight-line method for real estate, which is property in the 27.5- or 39-year class. However, you can also choose to use straight-line depreciation for any other property, if you wish.

Warning

Generally, if you exercise your option to use any of the variations of MACRS you must use it for all assets of the same class that you placed in service during the year. Once you make the election you cannot change it.

For more information on using any of these alternative MACRS methods, and for the tables showing the applicable depreciation percentages, see the IRS's free Publication 946How to Depreciate Property.

Alternative Depreciation System May Be Required

The Alternative Depreciation System (ADS) straight-line method must be used in certain situations, rather than the standard MACRS method. In addition, assets acquired and put in service before 1987 must continue to be depreciated using the Accelerated Cost Recovery System (ACRS).

The ADS straight-line method must be used in certain situations when normal MACRS is not available; for example, if you've used the standard mileage rate method of deducting vehicle expenses and want to switch to the actual cost method in a later year. ADS must also be used if your business use of listed property drops to 50 percent or less for a year.

For property purchased before 1999, the ADS system must be used to compute your alternative minimum tax (AMT) liability, if you're unlucky enough to have to worry about the AMT and have older property that is not fully depreciated. Taxpayers who have paid or are likely to pay AMT will need to maintain depreciation records under both the alternative system and the regular MACRS.

Tip

For depreciable real estate placed into service in 1999 or later, you can use the same depreciation allowable under normal MACRS even if you are subject to the AMT, so you no longer have to maintain two sets of records.

For non-real estate property placed in service in 1999 or later, you may use the MACRS recovery periods for AMT purposes but must use a slower recovery method; namely, either the straight-line or the 150 percent declining balance method, rather than the 200 percent declining balance method.

Elect ADS to Depreciate Assets More Slowly

You can elect to use the slower ADS depreciation even if you are not required to use it by law. For example, if you want your earnings to appear larger on your income statement, you might opt to use ADS for any new property you purchase because it will result in lower depreciation deductions.

Warning

If you begin depreciating a particular asset using ADS, you must continue using it for the life of the asset - you can never switch back to the ordinary MACRS system. Also, if you elect this method for one item in an asset class, you must use it for all assets of that class that you placed into service that year, unless the asset is real estate.

For more information on how to use ADS and for the tables showing the applicable depreciation percentages, see the IRS's free Publication 946How to Depreciate Property.

Methods Used to Depreciation Pre-1987 Property

If you began operating your business before 1987, you might be using some assets that were put into service before that year. If so, you'll have to continue to use a set of depreciation methods known as "ACRS," which stands for Accelerated Cost Recovery System.

Accelerated Cost Recovery System (ACRS). ACRS used shorter recovery periods for most assets than those currently in use under MACRS. Personal property was classified as 3-year (cars, trucks, racehorses, tractors); 5-year (computers, copiers, equipment, furniture, petroleum storage facilities, single-purpose horticultural and agricultural buildings); or 10-year (theme-park structures, public utility property, manufactured homes and railroad tank cars). The normal ACRS recovery periods for property of these types purchased before 1987 would already have expired, unless a longer period was elected as described below.

Under ACRS, real estate is depreciable over 15 years if placed into service after 1980 but before March 16, 1984; over 18 years if placed into service on or after March 16, 1984 but before May 9, 1985; and over 19 years if placed into service on or after May 9, 1985 through the end of 1986.

Unless you selected the "alternate ACRS" method of depreciation, with its longer recovery periods of 25, 35 or 45 years for certain types of depreciable property, you should no longer be depreciating ACRS property on your books, because more than 19 years have passed since ACRS was available.

To find the depreciation deduction for any of these properties, get a copy of IRS Publication 534,Depreciating Property Placed in Service Before 1987,which you can obtain for no charge by calling 1-800-TAX-FORM, or download it from the IRS website.

Depreciation for Property Acquired Before 1981. For property placed into service before 1981, you could generally use any reasonable method for depreciating property based on its tax basis, useful life, and salvage value.

If you still hold such property and it is not yet fully depreciated, you must continue to use the same method you've established in previous years, or get IRS permission to change your accounting method by filing IRS Form 3115. There is an exception to this rule if you want to change to a straight-line method; in that case, you generally don't need advance permission, although you must attach a statement to your tax return that explains what you're doing. See IRS Publication 534, Depreciating Property Placed in Service Before 1987,for more details.

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