As a general rule, any amounts you invest in fixed assets for use in your business cannot be deducted in full in the year you incurred the expenditure. These amounts can however be deducted in the form of depreciation deductions over a number of years, until you fully recover the cost of the property. The objective of this article to enlighten you how to figure what portion of the cost of your business or investment property you can deduct from your income each year, and also to make you aware of the special Section 179 deduction, and the special depreciation allowances, that can allow you even greater deductions in the year of purchase.
DEPRECIATION IN GENERAL
Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property used in business, over a certain period of time. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property. Most types of tangible property used in business (except land), such as buildings, machinery, vehicles, furniture, and equipment, are depreciable. Likewise, certain intangible property, such as patents, copyrights, and computer software, are also depreciable.
When you purchase investment and income producing property (machinery, equipment, motor vehicles, buildings, etc.) that have a useful life lasting substantially beyond the tax year, you generally cannot deduct the cost of this property from income in the year you acquire them. Tax law allows you however, to recover the cost of certain investment and income-producing property, by taking yearly deductions for depreciation, over the life of the property. Depreciation is the decrease in the value of property, over the time it is used in the business.
Before we go any further, we must make a distinction between real and personal property:
- Real property is any investment in real estate (land and buildings).
- Personal property is any other property that is not real property (machinery, equipment, cars, furniture, computers, etc).
The form or schedule you use to report your depreciation deductions depends on the use of the property being depreciated. For example, if you are using your property in your self-employed business, you will report your depreciation deductions on Schedule C. If you are using your real property in rental activities, you will report your depreciation deductions on Schedule E.
You can depreciate property ONLY if:
- You used it for business, or hold it to produce income.
- You expected it to last for more than one year.
- It has a limited useful life. (That is why land is never depreciated; land has an infinite life).
You cannot take a depreciation deduction for the following types of property:
- Real or personal property that you use for personal (non-business) purposes.
- Items placed in service and disposed of in the same year.
Most leased property.
- Inventory or stock in trade.
There are additional rules and requirements for depreciating property that is likely to be used for both personal and business purposes (see listed property below).
THE DEPRECIATION DEDUCTION
As already defined, depreciation is the process of allocating the cost of an asset over its useful life, by taking yearly depreciation deductions. To claim a depreciation deduction, the following rules apply:
- You must own the property and use it in your business, or you must use it for producing income.
- The depreciation deduction must be a percentage of the basis (cost) of depreciable property, and must be taken over the useful life of the property.
- Both the percentage rates and the useful lives of each category of property are determined by IRS rules.
- If your property is depreciable, you must take the depreciation deductions.
You can depreciate both tangible and intangible property.
Tangible property comprises of property that you can see or touch, and includes all real and personal property. Tangible property includes buildings, machinery, equipment, motor vehicles, furniture, etc.
Intangible property is generally property that cannot be seen or touched, but which has value. Intangible property includes goodwill, certain computer software, copyrights, patents, etc.
You begin taking depreciation deductions when you place property in service for use in your trade or business. Property is placed in service when it is ready and available for its specific use, which means basically, when the asset is in the position and location that makes it ready for use in your business.
You stop depreciating property after you have fully recovered its cost, or when you retire the property from service, whichever comes first:
- The cost is fully recovered when your Section 179, and depreciation deductions are equal to your cost or investment in the property.
- Property is retired from service when you permanently withdraw it from use in your trade or business, or from use in the production of income.
There are basically two depreciation systems currently being used in the United States:
The Modified Accelerated Cost Recovery System (MACRS), and the Accelerated Cost Recovery System (ACRS). MACRS replaced ACRS in 1986, and is the depreciation system used for most property placed in service after December 31, 1986.
Under these systems, the cost (basis) of tangible property is recovered over a specified period of time by taking annual deductions for depreciation. The particular system of depreciation that you will use to figure your depreciation deduction depends basically on: (a) the type of property, and (b) when it was placed in service. Generally, if you are depreciating property you placed in service before 1987, you must ACRS. For property placed in service after 1986, you generally must use MACRS.
For each category of property, the IRS provides MACRS and ACRS tables that give the depreciation rate (the percentage of the cost you can deduct) for each year the property is in use.
To deduct depreciation, you can use either a straight-line method, or you can use an accelerated method.
- The straight-line method of depreciation provides equal deductions for each year of useful life.
- Accelerated methods allow you larger deductions during the early years, thus resulting in faster recovery of the cost of the property.
The depreciation method that you use for any particular asset is fixed at the time you first place the asset into service, and thus cannot be changed. So, whatever rules or tables are in effect for that year must be followed as long as you own the property.
The Modified Accelerated Cost Recovery System (MACRS)
You must use the MACRS system to depreciate most tangible depreciable property placed in service after 1986, and also to depreciate real property acquired before 1987 that you changed from personal use to business or income-producing use after 1986.
MACRS cannot be used to depreciate the following types of property:
- Intangible property.
- Films, videotapes and recordings.
- Certain real and personal property placed in service before 1987.
MACRS essentially consists of two systems:
- General Depreciation System (GDS). This system is a combination of accelerated methods and the straight-line method. You use this system to depreciate most tangible property.
- Alternative Depreciation System (ADS). You use this system when you are specifically required by law to use it, or when you elect to use it. The ADS is essentially a straight-line method, and must be used in certain situations when normal MACRS is not available.
Depreciation calculations are based on the MACRS percentage tables, which incorporate the different depreciation conventions (see below). To use the MACRS tables, you need to know the following about your property:
- Its basis (cost).
- The property class it belongs to; and its recovery period.
- The date it was placed in service.
- The convention to use.
Your basis or cost, is your investment in the property, and is usually the amount that you purchased the property for. This cost includes any sales tax you might have paid on the property, plus any shipping costs, installation costs, and testing fees. Your yearly depreciation deduction is a percentage of the basis of your property.
If you change personal use property to business use, your basis in the property for depreciation purposes, is the lesser of the following: (a) the fair market value of the property on the date you change it from personal use to business use, or (b) your original cost basis, adjusted for the cost of improvements, and certain tax deductions.
If you use property for both personal and business purposes, you can claim a depreciation deduction ONLY for the percentage of the basis that applies to the business use of the property.
-The property class establishes the recovery period for the property, that is, the number of years over which you can take the depreciation deduction.
-Under GDS, property is assigned to one of 8 classes.
-The shorter the recovery period, the sooner you recover the cost of the property through your depreciation deductions.
-The class that property is assigned to is generally determined by its class life, which is the number of useful years assigned by tax law.
-Residential rental property and nonresidential real property have different recovery periods, which depend on the year they were placed in service.
-Additions and improvements are treated as separate property for depreciation purposes.
The established property classes under the General Depreciation System (GDS) are the following:
- 3-year property: Tractor units, racehorses over two years old, and horses over 12 years old when placed in service.
- 5-year property: Automobiles, taxis, buses, trucks, computers and peripheral equipment, office machinery, and any property used in research and experimentation. This property class also includes breeding and dairy cattle.
- 7-year property: Office furniture and fixtures, and any property that has not been designated as belonging to another class.
- 10-year property: Vessels, barges, tugs, and similar water transportation equipment, single-purpose agricultural or horticultural structures, and trees or vines bearing fruit or nuts.
- 15-year property: Depreciable improvements to land such as shrubbery, fences, roads, and bridges.
- 20-year property: 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.
Under MACRS, conventions establish when the recovery period of depreciable property begins and ends. The convention you use determines the number of months for which you can claim depreciation in the year you place property in service, and in the year you dispose of the property. Conventions also determine the depreciation table to use, and how much depreciation you can deduct each year of the property’s recovery period. There are three conventions under the MACRS system.
1. The half-year convention: Under this convention, all personal property is treated as having been placed in service, or disposed of, at the midpoint of the year, regardless of when in the year you actually begin to use the property, or when you retired the property from service. This means then, that you deduct a half-year depreciation in the year you acquired or disposed of the property.The half-year convention is the standard for depreciating all personal property, and must be used unless the mid-quarter convention (see below) rules apply.
2. The mid-quarter convention: This convention must be used if the depreciable basis of personal property placed in service during the last 3 months of the year, exceeds 40% of the total depreciable basis of all personal property placed in service for the entire year.
Under the mid-quarter convention, all property placed in service during a particular quarter, is treated as having been acquired at the mid-point of that quarter. The following also apply to the mid-quarter convention:
There is a separate MACRS percentage table for each quarter.
If you are required to use the mid-quarter convention, you must use it on all personal property placed in service for the entire year.
Property that is depreciated under the mid-quarter convention in the first year it is placed in service must be depreciated under the mid-quarter convention for each subsequent year.
You can avoid the mid-quarter convention by planning your purchases so that over 40% of the cost doesn’t get spent at the end of the year, for example, by buying earlier in the year, or waiting until January of the next year.
3. The mid-month convention: This convention is used for nonresidential real property and residential rental property. Under this convention, all property is treated as having been placed in service, or disposed of, at the midpoint of the month in which you begin or end the use of the property.
The Section 179 deduction
Under Section 179 of the Inland Revenue Code (IRC) you can elect to deduct all or part of the cost of certain qualifying property (up to a certain limit) in the first year you place the property in service, instead of taking yearly depreciation deductions over the recovery period.
Essentially, Section 179 allows businesses to deduct the full purchase price of qualifying property purchased or financed during the tax year. That means, then, that if you buy a piece of qualifying equipment, you can potentially deduct the full purchase price from your income in the year of purchase. This is an incentive created by the U.S. Government to encourage businesses to buy equipment and invest in themselves.
You must follow the rules below, if you choose to elect the Section 179 deduction:
- You must use Form 4562, Depreciation and Amortization, to make the election.
- Generally, qualifying property must be tangible property acquired by purchase, for use in your trade or business.
- For property with some element of personal use, you cannot elect the deduction, unless the business use is more than 50% of its total use, in the year you placed it in service.
- In figuring your Section 179 deduction, you must use only the business use cost of the property; consequently, your Section 179 deduction cannot be more than the business use cost of the qualifying property.
- You can choose to deduct only a part of the cost (the elected cost) and depreciate the rest over the applicable recovery period.
- You can revoke an election for a Section 179 deduction without IRS approval. You make this revocation on an amended return.
- You must keep adequate records identifying each piece of Section 179 property.
Certain types of property do not qualify for the Section 179 deduction. These properties include:
- Property held only for the production of income.
- Rental property.
- Property used predominantly to furnish lodgings.
- Property acquired from relatives.
There are limits to the amount of the Section 179 deduction that you can take in a given year. The following factors determine the maximum amount you can claim under Section 179:
- For tax year 2011, the total amount that you can elect under Section 179 cannot exceed $500,000.
- The $500,000 maximum must be reduced one dollar for each dollar that the cost of the qualifying property exceeds $2,000,000.
- The total cost of the property you can deduct cannot exceed the amount of your taxable income from the active conduct of any trade or business, including salaries, wages, or any other employee compensation that you might have taken. Any amount that is not deductible because of the taxable income limitation can be carried over to the next year.
- You must use the actual cost of the business use portion of the property (not the elected cost) in figuring if the cost is within limits.
The Section 179 deduction and depreciation limits for auto
There are annual depreciation limits for passenger cars, light trucks, and vans. The total depreciation deduction, including both the Section 179 expense deduction, as well as Bonus Depreciation (see below) on these vehicles, is limited to $11,060 for cars and $11,160 for trucks and vans.
The above limits do not apply to the following vehicles:
- Ambulances or hearses used specifically in your business.
- Taxis, transport vans, and other vehicles used specifically for transporting people or property.
- Qualified non-personal use vehicles specifically modified for business use. For example, vans without seating behind the driver, vehicles with permanent shelving installed, and vehicles with the company’s name painted on the exterior.
SUVs weighting above 6,000 pounds, but no more than 14,000 pounds, qualify for expensing up to $25,000, if the vehicle is financed and placed in service during the year, and meets other conditions.
Bonus depreciation is an income tax deduction that allows a taxpayer to deduct 100% of the cost of certain property placed in service during 2011. To be eligible for the 100% bonus depreciation, the equipment must meet the following requirements:
- The equipment must be depreciable under the Modified Accelerated Cost Recovery System (MACRS), and have a depreciation recovery period of 20 years or less.
- The equipment must be new, meaning; the original use of the equipment must commence with the taxpayer who is claiming the bonus depreciation.
- The equipment must be purchased after September 8, 2010 and before January 1, 2012.
- The equipment must be placed in service before January 2, 2012.
Section 179 deduction vs. bonus depreciation
The most important difference between these two deductions, is that only new equipment qualifies for the bonus depreciation, while both new and used equipment qualify for the Section 179 deduction (as long as the used equipment is “new to you”).
Listed property is any property the IRS considers likely to be used for both business and personal purposes, and includes the following:
- Passenger automobiles weighing 6,000 pounds or less.
- Any other property used for the transportation of people (trucks, buses, boats).
- Any property used for entertainment, recreation, or amusement (cameras, DVD players, cellular phones, etc.)
- Computers not used exclusively at a regular business establishment.
There are special rules, and record-keeping requirements for depreciating listed property. These are as follows:
Only the business-use part of the cost can be depreciated.
To depreciate listed property using the GDS system, the qualified business use of the property must be more than 50% of its total use. This is called the Predominant Use Test.
If the qualified business use of the property is 50% or less, you must depreciate using the ADS (straight-line) system and you cannot claim a Section 179 deduction.
To take a depreciation deduction for listed property, you must be able to prove business use, with supporting records and evidence.
Disposition of property
A disposition of property is the permanent withdrawal of property from use in a trade or business. A withdrawal can be made by sale, exchange, retirement, abandonment, or destruction. A disposition before the end of the recovery period is called early disposition.
For properties depreciated under MACRS, you are allowed a depreciation deduction in the year of disposition. This deduction is usually a percentage of the MACRS deduction for that year of service. The percentage will be different, depending on the convention you are using.
In tax law, amortization refers to the cost recovery system for intangible property. To claim a deduction for amortization, the intangible property must be held either for use in a trade or business, or for the production of income.
An intangible asset is typically anything non physical in nature, and hard to assign an actual value to. Qualified intangible property includes noncompetitive trade agreements, goodwill, trademarks, the value of a worker’s expertise, trade and franchise names, etc. Amortization is the practice of deducting the cost of an investment in a qualifying intangible asset over the estimated life of the asset, which is usually a 15-year period, regardless of the actual useful life of the asset.
Amortization vs. depreciation
Amortization is similar to the straight-line method of depreciation. It is not surprising to find depreciation and amortization being used interchangeably. This is because all methodologies for allotting amortization to each tax period are basically the same as methodologies for depreciation. In principle, however, depreciation refers to tangible assets, while amortization refers to intangible assets.
Investigating the potential for a new business, and actually getting it started, can be a very costly undertaking. Under the general rules for business deductions, you cannot deduct these expenses, because you can only deduct expenses for an existing trade or business. By definition, you incur your startup expenses prior to the time that your business was in existence. Tax law, however, allows you take yearly deductions for your business startup costs, through the process of amortization.
For costs paid after October 22, 2004, you can elect to deduct a limited amount of start-up and organizational costs in the year incurred. The remaining costs, however, can be amortized ratably over a 180-month period. The amortization period starts with the month you begin operating your active trade or business.
Completing Form 4562
You must complete Form 4562, Depreciation and Amortization, and attach it to your return if the any of the following apply to you.
- You claim a Section 179 deduction or carryover.
- You claim a depreciation deduction for property placed in service in the current year.
- You claim a depreciation deduction on any vehicle or other listed property, regardless of the year placed in service.
- You claim a depreciation deduction for any vehicle using the standard mileage rate, unless the deduction was reported on Schedule C or C-EZ.
- You claim a deduction for amortization of costs that begin in the current year.
You must complete and file a separate Form 4562 for each business or activity for which you are claiming a depreciation deduction. The amount on line 22 of Form 4562 must be entered on the form or schedule (that is, Schedule E, or Schedule C) on which you are claiming the depreciation.
You are not required to file Form 4562 to report depreciation or amortization for non-listed property for the years after the property was placed in service.
A depreciation worksheet is provided in the instructions for Form 4562. You use this worksheet to figure your depreciation deduction, and also for record keeping.
If you are an employee who claims depreciation for business uses of your vehicle, you must use Form 2106 instead of Form 4562.
Some Tax Planning Points
If you have not claimed depreciation for your property, or have not claimed the correct amount, the amount of depreciation that should have been claimed, even though you might not have claimed it, will be subtracted from the basis (cost) of your property when it is sold. This can have adverse effects on your finances, because what it will do in effect is to increase any capital gain (or decrease any capital loss) that might be realized upon sale of the under-depreciated property.
To claim the special depreciation allowance for listed property, the property must be used more than 50% in a trade or business.
You can claim a depreciation deduction for computer software if: (a) it is readily available for purchase by the general public, (b) it is subject to a nonexclusive license, and (c) it is not substantially modified.
Computer software is intangible property; therefore it cannot be depreciated under MACRS. You must depreciate the cost of computer software over 36 months, using the straight-line method. The cost of computer software that does not meet the above criteria must be amortized.
Off-the-shelf computer software that is placed in service after 2002, is qualifying property for the purposes of the Section 179 deduction.