Depreciation is a way of spreading out the cost of a capital asset over time. By using depreciation, the total cost of an asset is expensed over a number of years referred to as the useful life or recovery period. For tax purposes, the recovery periods for various types of assets are specified by the IRS in the United States.

The simplest method of depreciation is the straight line depreciation method, which simply deducts the cost of an asset evenly over the course of its recovery period. However, other methods of depreciation such as the declining balance method result in larger expenses in the early years of an asset's life. 

An organization can choose different methods of depreciation for financial reporting purposes and for tax purposes. The IRS specifies the depreciation method and rate that must be used for tax purposes in a system called the modified accelerated cost recovery system (MACRS). The two methods used under MACRS are the straight line method and the declining balance method.

This article will provide an overview of the straight line and declining balance depreciation methods and the relationship between depreciation method and cost segregation.

Depreciation Methods

Before discussing common depreciation methods in detail, it is important to understand the following terms:

• Salvage value is the book value of an asset at the end of its recovery period. The salvage value is what the business may expect to receive in exchange for selling the asset. The salvage value for many assets is zero.

• Useful life or recovery period, as previously mentioned, is the number of years over which an asset will depreciate for tax and accounting purposes

• Depreciable basis is the amount of an asset’s cost that is subject to depreciation. When an asset is placed in service, the depreciable basis is equal to its cost to you, less the salvage value. The depreciable basis decreases every year by the amount of depreciation expense claimed.

A Note About Depreciation in the First Year

Taxpayers are generally not allowed to claim a full year of depreciation during the first year an asset is placed in service. Instead, a partial year of depreciation is taken in the first year. Calculating this partial depreciation depends on the type of asset and the depreciation method being used. Some assets must be depreciated using the half-month, half-quarter, or half-year conventions. Details on how to implement these conventions can be found in IRS Publication 946.

For an asset with a five-year recovery period using the mid-year convention, the rate of depreciation in year one would be 10 percent. For years two through five, the depreciation rate would be 20 percent. In year six, the remaining 10 percent of depreciation would be claimed.

To more clearly illustrate the different depreciation methods, the partial year of depreciation will not be taken into account in the examples below. To determine the actual depreciation rate for tax purposes, you should consult the MACRS table appropriate to the asset’s recovery period, depreciation method, and in-service date.

Straight Line Depreciation

Straight line depreciation is the simplest method of depreciation. The yearly depreciation expense is equal to the depreciable basis of the asset divided by its recovery period. A five-year asset with a depreciable basis of $5,000 would be subject to $1,000 of depreciation per year

Expressed in terms of rate, the annual rate of depreciation is equal to 100 percent divided by the recovery period. A five-year asset using the straight line method would be subject to an annual depreciation rate of 20 percent. The 20 percent applies to the unadjusted basis of the asset.

Straight line depreciation allows taxpayers to claim a consistent deduction over the life of the asset. This method of depreciation can be advantageous if the company anticipates lower income in the early years of an asset’s life, since larger deductions are still available in later years. However, for assets with longer depreciable lives, such as commercial buildings, it can take years to write off a significant portion of the asset’s cost.

Declining Balance Depreciation

The declining balance method of depreciation is an accelerated depreciation method. This method results in larger depreciation deductions in the early years of business ownership. The yearly depreciation rate is equal to the declining balance percentage divided by the recovery period. The declining balance method uses a higher percentage than the straight line method. For example, the double declining balance method uses a percentage of 200 percent. For a five-year asset, the double declining balance rate would be 40 percent per year.

Multiply the declining balance rate by the adjusted basis to determine the depreciation expense. The adjusted basis is equal to the asset’s original basis minus accumulated depreciation. For a $5,000, five-year asset, the first-year depreciation would be $2,000 (40 percent of $5,000). In year two, the basis would be adjusted to $3,000, and the depreciation expense would be $1,200 (40 percent of $3,000).

For tax purposes, an asset must switch from the declining balance method to the straight line method beginning in the first year in which the straight line method would give an equal or greater deduction. MACRS tables account for this change in method.

The benefit of the declining balance method is that it allows for larger deductions in the early years of ownership. For taxpayers in need of more deductions, declining balance is often the preferred method.

Which Depreciation Method Should I Use?

The modified accelerated cost recovery system (MACRS) is generally the appropriate method to depreciate property for tax purposes in the United States. Detailed information on how to apply MACRS can be found in IRS Publication 946: How to Depreciate Property. The publication contains tables that outline the appropriate depreciation rate for an asset based on its recovery period, depreciation method, and in-service date.

Certain types of property are allowed to depreciate using the 150 percent or 200 percent declining balance method, which allows for increased depreciation in the early years of ownership. Other types of property, such as nonresidential and residential real property, must use the straight line method.

Taxpayers are generally allowed to elect for a more conservative method of depreciation. For example, if you determine that a five-year asset is eligible for depreciation using the 200 percent declining balance method under MACRS, you can elect to use either the 150 percent declining balance method or the straight line depreciation method instead.

Effects of Cost Segregation

Because the recovery periods and depreciation methods for tax purposes are specified by the IRS, there are limited ways of increasing depreciation. Nonresidential real estate will generally be depreciated using the straight line method over 39-years under MACRS. However, one way of increasing depreciation deductions is by reclassifying property using a cost segregation study.

A cost segregation study identifies portions of a building that are currently being treated as nonresidential or residential real property, but should in fact be classified as 5-,7-, or 15-year property. By reclassifying real property into categories with shorter recovery periods, cost segregation studies allow taxpayers to use more aggressive methods of depreciation such as 200 percent and 150 percent declining balance methods. For property that is already in service, this change in recovery period is implemented using a Form 3115. No amended tax returns are required to implement a cost segregation study.

Certain property with a useful life of 20 years or less qualifies for bonus depreciation, allowing for even larger deductions in the early years of ownership.

A portion of your real estate may be eligible for accelerated depreciation. Use our online form to request a no-cost projection of the tax savings available to you under the current law.

For more information please contact our Director of Cost Segregation at clayton@lumpkinagency.com.

The information provided in this blog is intended for general information only, and is not meant to constitute tax advice.