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What Is Depreciation?

Depreciation is the deduction, each year, of part of the cost or other basis of assets used in a trade or business or for production of income. Ordinarily, if you purchase business or income-producing property with a useful life beyond one year, you must spread the deduction of that cost over more than one year. You can't simply claim a deduction for the entire cost in the year you buy the asset. Generally, one of two sets of rules applies to the depreciation of assets:

  • Modified Accelerated Cost Recovery System (MACRS) for assets placed in service after 1986
  • Accelerated Cost Recovery System (ACRS) for assets placed in service after 1980 and before 1987

A third system, useful-life depreciation, applies to property outside either MACRS, ACRS, or assets placed in service before 1981.

What Is Depreciable Property?

In order to be depreciable, property must have all of the following characteristics:

  • It must be used in a trade or business or used for production of income
  • It must have an accurately determined useful life of more than one year
  • It must be something that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes

Technical Note: The following types of property aren't depreciable:

  • Property placed in service and then disposed of during the same tax year
  • Property used entirely for personal purposes and not at all for business or income-producing purposes
  • Land or natural resources found in the ground (because they aren't subject to wear and tear, but natural resources may be subject to a depletion allowance, which takes the place of depreciation)

Who Can Claim Depreciation Deductions?

In general, the owner of depreciable property can deduct an allowance for depreciation. A landlord can claim depreciation for property already on the premises when he or she leases them out or on improvements he or she makes during the lease term. A landlord can't claim depreciation for property that, under the lease, the tenant must replace at his or her own expense.

What form Do You Need?

The form often required for claiming a depreciation deduction is Form 4562. C corporations must file Form 4562 when claiming any depreciation deduction. Individuals, partnerships, and S corporations need to file Form 4562 if they are claiming depreciation for property placed in service during the tax year or for listed property. Otherwise, these latter entities don't need to file this form.

Technical Note: If an individual, partnership, or S corporation is claiming a Section 179 deduction or carryover, Form 4562 must be filed.

The Modified Accelerated Cost Recovery System (MACRs) MACRs Recovery Periods

Under MACRS, an asset is assigned to a property class established by IRS regulations (see MACRS recovery classes discussion later). Each recovery class has two possible recovery periods:

  • General Depreciation System (GDS): Also referred to as regular MACRS, GDS uses the shortest recovery period allowing most rapid recovery of cost.
  • Alternative Depreciation System (ADS): ADS, also called alternate MACRS, offers a longer recovery period. In most situations, ADS is an option to regular MACRS. Sometimes, however, ADS is mandatory.

MACRS Depreciation Methods

The following is a list of depreciation methods that may apply under MACRS:

  • 200 percent declining balance over a GDS recovery period
  • 150 percent declining balance over a GDS recovery period
  • Straight-line depreciation over a GDS recovery period
  • 150 percent declining balance over an ADS recovery period (for property placed in service before 1999)
  • Straight-line depreciation over an ADS recovery period

The declining balance (DB) method involves dividing either 200 percent or 150 percent (the declining balance percentage) by the recovery period for that type of asset to get the annual depreciation rate. Under the declining balance method, the depreciation schedule switches to straight-line when the straight-line depreciation is more than the declining balance depreciation.

Example(s): The Mauve Cab Company depreciates its taxis. Taxis are depreciated using the 200 percent declining balance method over a five-year recovery period. The depreciation rate equals the declining balance percentage (200 percent), divided by the recovery period (five years), or 40 percent of the remaining basis of the taxi, but when straight-line depreciation produces a larger deduction, the depreciation schedule switches to straight-line.

For 3-, 5-, 7-, and 10-year class property you placed in service before 1999 and that you chose to depreciate using the 150 percent declining balance rate, you had to use an ADS recovery period. For such property placed in service after 1998, you can use the same recovery period you would have used if you had chosen the 200 percent declining balance rate; in other words, you can use the GDS recovery period.

Optional MACRS Recovery Methods

For any assets other than real estate, you may make the following special elections instead of the 150 percent or 200 percent declining balance methods:

  • Straight-line depreciation over the regular MACRS (GDS) recovery period,
  • Straight-line depreciation over the alternative depreciation system (ADS), or
  • 150 percent declining balance over ADS for 3-, 5-, 7-, or 10-year property (AMT method)

If you make a special election, you should attach a statement to your tax return identifying the property and the election. Once made, the election covers all property of that class (see recovery class discussion that follows) placed in service that year, and it is irrevocable.

MACRS Recovery Classes

Under the Internal Revenue Code, MACRS property is assigned to recovery classes with varying depreciation periods. The following is a summary of the classes:

Recovery Class

Property's Class Life (in Years)

Examples

3-Year (200% DB)

4 or less

Tractor units for use on the road, racehorses over 2 years old, other horses over 12 years old

5-Year (200% DB)

Between 4 and 10

Taxis, buses, autos, computers, copiers, typewriters, and office equipment

7-Year (200% DB)

10 or more, but less than 16

Office furniture and fixtures (such as desks and cabinets)

10-Year (200% DB)

16 or more, but less than 20

Vessels, barges, tugs, single-purpose agricultural structures, trees or vines bearing fruit or nuts

15-Year (150% DB)

20 or more, but less than 25

Parking lot, sidewalk, road, fence, or other land improvements, gas stations

20-Year (150% DB)

25 or more

Farm buildings

25-Year* (straight-line)

N/A

Certain water utility property and sewers

27.5-Year* (straight-line)

N/A

Rental houses and apartments

39-Year* (straight-line)

N/A

Office buildings, warehouses, and qualified home offices

*These classes are for specific types of property, rather than a class life range. IRS Publication 946 has a more comprehensive listing of the assets that fall into the above classes. Any asset not assigned to a defined class is placed in the 7-year (GDS) recovery class.

Tip: Under the Food, Conservation, and Energy Act of 2008 (otherwise known as the Farm Bill), as extended, a race horse will have a three-year recovery period if it is: (1) placed in service before January 1, 2021, or (2) placed in service after December 31, 2020 and is more than two years old at the time that it is placed in service by the purchaser.

Tip: The Emergency Economic Stabilization Act 0f 2008 allows a 5-year recovery period for qualified farming property. Qualified farming property is machinery or equipment used in a farming business. Original use of the property must have begun with the taxpayer after December 31, 2008, and the property must have been placed in service on or before December 31, 2009. The property cannot be a grain bin, cotton ginning asset, fence, or other land improvement.

Excluded Property Under MACRS

You cannot depreciate the following types of property using MACRS:

  • Property depreciated under a units-of-production method or other property whose depreciation isn't expressed in terms of years
  • Public utility property when a normal accounting method isn't used
  • Any movie, videotape, or sound recording
  • Business automobiles under the standard mileage rate
  • Certain property placed in service in churning transactions
  • Intangible property
  • Certain property covered by transition rules

MACRS Conventions

The MACRS conventions define, for the purposes of depreciation, when property has either been placed in service or disposed of. The most commonly used convention is the half-year convention, which applies to all property except (1) residential rental and nonresidential real estate and (2) property subject to the mid-quarter convention. It treats all property placed in service or disposed of during the tax year as placed in service or disposed of at the midpoint of the tax year.

The mid-month convention applies to residential rental and nonresidential real estate. It treats all property placed in service or disposed of during any month as placed in service or disposed of at that month's midpoint. The mid-quarter convention applies when the total basis of all property placed in service during the last three months of the tax year exceeds 40 percent of the total basis of all property placed in service during the tax year. It treats all property placed in service or disposed of during any quarter as placed in service or disposed of at that quarter's midpoint.

Caution: When determining the total basis of all property for mid-quarter convention calculations, don't include the basis of the following:

  • Residential rental property
  • Nonresidential real estate
  • Property placed in service and disposed of in the same tax year
  • Property expensed under Section 179

Alternate Minimum Tax Adjustments to MACRS Deductions

When computing alternative minimum tax (AMT), certain adjustments are made to MACRS deductions. Consult a tax professional.

Alternative Depreciation System (ADS)

The Alternative Depreciation System (also called Alternate MACRS) applies straight-line depreciation over the applicable recovery period. The ADS depreciation method is optional with respect to most types of property but mandatory in a few cases. You should keep in mind the following if you elect the ADS method:

  • Your election is irrevocable and applies to all property in that class placed in service in the tax year of the election
  • You must make your election by the due date (including extensions) of the return for the year in which the property is placed in service
  • You should attach a statement to the return identifying the property and also identifying the election
  • The half-year and mid-quarter conventions apply

You must use ADS with straight-line depreciation with these types of property:

  • Certain imported property (specified in an executive order of the president)
  • Property used predominantly outside the United States (there are exceptions for vessels, rolling stock, aircraft, and containers)
  • Tax-exempt-use property
  • Tax-exempt bond-financed property
  • Luxury cars and other listed property used 50 percent or less for business

You must use ADS with 150 percent declining-balance depreciation with alternative minimum tax, except when real estate or straight-line depreciation for regular depreciation is involved.

Temporary 50 Percent (or 100 Percent) Additional First-Year Depreciation Deduction

Under the Economic Stimulus Act of 2008, the American Recovery and Reinvestment Act of 2009, the Small Business Jobs Act of 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the American Taxpayer Relief Act of 2012, the Taxpayer Increase Prevention Act of 2014, the Protecting Americans from Tax Hikes Act of 2015, and the Tax Cuts and Jobs Act, a special 50 percent (or 100, 80, 60, 40, 30, or 20 percent) additional first-year depreciation deduction is allowed for qualified assets (for both regular and alternative minimum tax purposes).

Qualified assets must meet the following requirements:

  • The asset must be acquired after December 31, 2007 and before January 1, 2027
  • Generally, the asset must be placed into service before 2027 (before 2028 for certain property)
  • The asset must be subject to the general rules of MACRS, and
  • One of the following must apply:
  1. The asset must be tangible property with a depreciable life of 20 years or less
  2. The asset must be water utility property
  3. The asset must be purchased computer software, or
  4. The asset must be qualified leasehold improvement property

Tip: The additional first-year depreciation deduction is increased from 50 percent to 100 percent for property placed in service after September 8, 2010 and before January 1, 2012 (before January 1, 2013 for certain property). For property acquired before September 28, 2017, the additional first-year depreciation deduction is 50 percent for property placed in service after September 27, 2017 and before January 1, 2018, 40 percent for property placed in service in 2018, 30 percent for property placed in service in 2019, and none for property placed in service after 2019 (decreases are one year later, i.e., 2019 and 2020, for certain property). For property acquired after September 27, 2017, the additional first-year depreciation deduction is 100 percent for property placed in service after September 27, 2017 and before January 1, 2023, 80 percent for property placed in service in 2023, 60 percent for property placed in service in 2024, 40 percent for property placed in service in 2025, 20 percent for property placed in service in 2026, and none for property placed in service after 2026 (decreases are one year later, i.e., 2024, 2025, 2026, and 2027, for certain property)..

Taxpayers can take a Section 179 expense deduction, this special first-year additional depreciation deduction, and the normal depreciation deduction taken in the first year (in that order).

Tip: For tax years ending after March 31, 2008, businesses can elect to claim additional research or AMT tax credits in lieu of bonus depreciation for qualified property placed into service after March 31, 2008 and before January 1, 2020. The amount of the refundable credit that can be claimed is equal to the lesser of: (1) 20 percent of the additional depreciation that would result from applying the bonus depreciation rules to otherwise bonus-eligible property acquired (or costs incurred in the case of self-constructed property), (2) 6 percent of the taxpayer's accumulated minimum tax and research credit carryovers that are attributable to taxable years beginning before 2006, or (3) $30 million. Taxpayers making the election must use the straight line method with respect to property that would otherwise be eligible for bonus depreciation.

Request Guide TRG

Special 30 Percent Additional First-Year Depreciation Deduction for Eligible "New York Liberty Zone" Property

Businesses in the New York Liberty Zone (the area of Manhattan located on or south of Canal Street; East Broadway — east of its intersection with Canal Street; or Grand Street — east of its intersection with East Broadway) may be eligible for their own special 30 percent additional first-year depreciation deduction (again, for both regular and alternative minimum tax purposes).

Qualified assets must meet the following requirements:

  • The original use of the asset must start after September 10, 2001
  • The taxpayer taking the deduction must acquire the asset on or after September 11, 2001
  • The asset must have been placed in service before 2007 (for nonresidential real property and residential rental property, the placed-in-service deadline is 2010)
  • Substantially all of the use of the property must be in the New York Liberty Zone
  • The asset must be subject to the general rules of MACRS, and
  • One of the following must apply:
  1. The asset must have a depreciable life of 20 years or less
  2. The asset must be water utility property
  3. The asset must be non-IRC Section 197 computer software, or
  4. The asset must be certain commercial real property or residential rental property

Again, a taxpayer can take a Section 179 expense deduction, this special additional first-year depreciation deduction, and the normal depreciation deduction taken in the first year (in that order).

Tip: A taxpayer can elect out of the additional first-year depreciation deduction for any class of property for any taxable year.

Caution: This additional first-year depreciation deduction was not available for property eligible for the special additional first-year depreciation deduction described above. (Property was eligible for only one additional first-year depreciation deduction.)

Special 50 Percent Additional First-Year Depreciation Deduction for Eligible "Gulf Opportunity (GO) Zone" Property

Businesses in the Gulf Opportunity (GO) Zone (that portion of the Hurricane Katrina disaster area determined by the President to warrant individual or individual and public assistance from the federal government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act by reason of Hurricane Katrina) may be eligible for their own special 50 percent additional first-year depreciation deduction (for both regular and alternative minimum tax purposes).

Qualified property must meet the following requirements:

  • The original use of the property in the Gulf Opportunity Zone must start on or after August 28, 2005
  • The taxpayer taking the deduction must acquire the asset on or after August 28, 2005
  • The asset must be placed into service before 2008, unless the property is self-constructed (2009 for residential rental property and nonresidential real property) (extended through 2011 for certain property, see below)
  • Substantially all of the use of the property must be in the Gulf Opportunity (GO) Zone
  • The asset must be subject to the general rules of MACRS, and
  • One of the following must apply:
  1. The asset must have a depreciable life of 20 years or less
  2. The asset must be water utility property
  3. The asset must be non-IRC Section 197 computer software, or
  4. The asset must be certain commercial real property or residential rental property

A taxpayer can take a Section 179 expense deduction, this special additional first-year depreciation deduction, and the normal depreciation deduction taken in the first year (in that order).

Tip: A taxpayer can elect out of the additional first-year depreciation deduction for any class of property for any taxable year.

Caution: This provision does not apply with respect to any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises. This provision also does not apply with respect to any gambling or animal racing property.

The Tax Relief and Health Care Act of 2006 and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extend the placed-in-service deadline for specified Gulf Opportunity Zone extension property to December 31, 2011. The extension applies to nonresidential real property or residential rental property in one or more specified portions of the Gulf Opportunity Zone ("substantially all the use" of this property must be in these specified areas).

The Acts also allows the additional first-year depreciation deduction in the case of personal property if substantially all the use of the property is in a building that qualifies as specified Gulf Opportunity Zone extension property, and the property is placed in service within 90 days of the date the building is placed in service.

Caution: However, in the case of nonresidential real property or residential rental property, only the adjusted basis of such property attributable to manufacture, construction, or production before January 1, 2012 is eligible for the additional first-year depreciation.

Tip: The specified portions of the Gulf Opportunity Zone are defined as those portions of the Gulf Opportunity Zone which are in a county or parish which is identified by the Secretary of the Treasury (or his delegate) as being a county or parish in which hurricanes occurring in 2005 damaged (in the aggregate) more than 60 percent of the housing units in such county or parish which were occupied (determined according to the 2000 Census).

Special 50 Percent Additional First-Year Depreciation Deduction for Qualified "Recovery Assistance" Property

The Food, Conservation, and Energy Act of 2008 (otherwise known as the Farm Bill) provides an additional first-year depreciation deduction equal to 50 percent of the adjusted basis for "qualified Recovery Assistance property," with rules substantially similar to the provisions that apply to qualified GO Zone property.

For property to be "qualified Recovery Assistance property," it must meet all of the following requirements:

  • The property must be property to which the general rules of the modified accelerated cost recovery system (MACRS) apply and (a) that has an applicable recovery period of 20 years or less, (b) is computer software other than computer software covered by IRC Section 197 (which provides 15-year amortization for many intangibles), (c) is water utility property, (d) is certain leasehold improvement property, or (e) is certain nonresidential real property or residential rental property.
  • Substantially all of the use of the property must be in the Kansas Disaster Area and in the active conduct of a trade or business by the taxpayer in the Kansas Disaster Area.
  • The original use of the property in the Kansas Disaster Area must begin with the taxpayer after May 4, 2007. Thus, used property may qualify if it hasn't been previously used within the Kansas Disaster Area. Also, Congress intends that additional capital expenditures incurred to recondition or rebuild property the original use of which in the Kansas Disaster Area began with the taxpayer would satisfy the "original use" requirement.
  • The property must be acquired by purchase by the taxpayer after May 4, 2007 and placed in service before January 1, 2009 (January 1, 2010 for qualifying nonresidential real property and residential rental property). Property doesn't qualify if a binding written contract for the acquisition of the property was in effect before May 5, 2007. However, property isn't precluded from qualifying merely because a binding written contract to acquire a component of the property is in effect before May 5, 2007. Property that is manufactured, constructed, or produced by the taxpayer for use by the taxpayer qualifies if the taxpayer begins the manufacture, construction, or production of the property after May 4, 2007 and before January 1, 2009 and the property is placed in service before January 1, 2009 and all other requirements are met. In the case of qualified nonresidential rental property and residential rental property, the property must be placed in service before January 1, 2010. Property manufactured, constructed or produced for the taxpayer by another person under a contract entered into before the manufacture, construction or production of the property is considered to be manufactured, constructed, or produced by the taxpayer.

Special 50 Percent Depreciation Deduction for Qualified "Disaster Assistance" Property

The Emergency Economic Stabilization Act of 2008 provides that in the case of qualified disaster assistance property, the depreciation deduction for the taxable year in which such property is placed in service shall include an allowance equal to 50 percent of the adjusted basis of the qualified disaster assistance property, and the adjusted basis of the qualified disaster assistance property shall be reduced by the amount of such deduction before computing the amount otherwise allowable as a depreciation deduction under this chapter for such taxable year and any subsequent taxable year. This bonus depreciation is not subject to AMT adjustment.

Qualified disaster assistance property means any property:

  • Which is qualified depreciable property (most tangible personal property, most computer software, qualified leasehold property, nonresidential real property, and residential rental property)
  • Substantially all of the use of which is in a disaster area with respect to a federally declared disaster occurring before January 1, 2010, and in the active conduct of a trade or business by the taxpayer in such disaster area
  • Which:
  • Rehabilitates property damaged, or replaces property destroyed or condemned, as a result of such federally declared disaster, except that, for purposes of this clause, property shall be treated as replacing property destroyed or condemned if, as part of an integrated plan, such property replaces property which is included in a continuous area which includes real property destroyed or condemned, and
  • Is similar in nature to, and located in the same county as, the property being rehabilitated or replaced
  • The original use of which in such disaster area commences with an eligible taxpayer on or after the applicable disaster date
  • Which is acquired by such eligible taxpayer by purchase on or after the applicable disaster date, but only if no written binding contract for the acquisition was in effect before such date, and
  • Which is placed in service by such eligible taxpayer on or before the date which is the last day of the third calendar year following the applicable disaster date (the fourth calendar year in the case of nonresidential real property and residential rental property)

Qualified disaster assistance property does not include:

  • Property eligible for 50 percent bonus depreciation under IRC Section 168(k) (temporary provision established by Economic Stimulus Act of 2008), currently available for 2008 to 2014 (see above)
  • Property eligible for 50 percent bonus depreciation under IRC Section 1400N, applicable to qualifying Gulf Opportunity (GO) Zone property (see above)
  • Gambling or animal racing property or property used in connection with golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities or stores that, principally, sell alcoholic beverages for off-premises consumption

Expanding of Qualified Disaster Expenses

Under the Emergency Economic Stabilization Act of 2008, a taxpayer may elect to treat any qualified disaster expense paid or incurred after December 31, 2007, as a deduction for the taxable year in which paid or incurred. For purposes of the provision, a qualified disaster expense is any otherwise capitalizable expenditure paid or incurred in connection with a trade or business or with business-related property that is:

  • For the abatement or control of hazardous substances that were released on account of a federally declared disaster
  • For the removal of debris from, or the demolition of structures on, real property damaged or destroyed as a result of a Federally declared disaster, or
  • For the repair of business-related property damaged as a result of a federally declared disaster

In any case in which costs are otherwise required to be capitalized, the costs may be deducted in the taxable year paid or incurred to the extent incurred as a result of a federally declared disaster. For purposes of this provision, "business-related property" is property held by the taxpayer for use in a trade or business, for the production of income, or as inventory. For purposes of recapture as ordinary income, any deduction allowed under this provision is treated as a deduction for depreciation and Section 1245 property for purposes of depreciation recapture.

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

 

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The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.

 


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