7.2. Depreciation and Amortization Expense
Since many assets are used in the production of income over a number of years, income is not properly measured if the entire cost of these assets is deducted when the assets are purchased. Depreciation is the accounting process of allocating and deducting the cost of an asset over a period of years. The term depreciation does not necessarily mean physical deterioration or loss of value of the asset. In fact, in some cases the value of the asset may increase while it is being depreciated. Certain assets, such as land, cannot be depreciated for tax purposes since they are not subject to wear, exhaustion or obsolescence. These assets remain on the taxpayer’s records at their original cost.
It is important to distinguish maintenance expense from depreciation. Depreciation expensedepreciation expenseAllocation of the cost of a tangible asset. is the deduction of a portion of the original cost of the asset, whereas maintenance expenses are those expenditures incurred to keep the asset in good operating order. For example, a taxpayer who purchases a truck for use in his business depreciates the cost of the truck over a period of years. Maintenance costs such as tires and repairs are deducted in the year they are incurred.
Simple financial accounting depreciation computation. The simplest method of depreciation is the straight-line method, which allocates an equal portion of the cost in each period of the asset’s life. Straight-line depreciation expense is calculated by deducting the salvage valuesalvage valueEstimated unallocated cost of an asset at the time of disposition. from the cost of the asset and dividing the result by the asset’s estimated useful lifeuseful lifeEstimate of the period of time that an asset will be productive; usually stated in years or months.. The formula is:
Bill buys an asset for business use. The asset cost $19,000 on August 1, 20X1, and has a $1,000 salvage value at the end of its three year (thirty-six months) useful life. Depreciation is calculated as follows:
($19,000 − 1,000)/36 months = $500 per month
At the end of 36 months, the asset has a basis of $1,000, equal to the asset’s estimated salvage value.
Depreciation computation for tax purposes. The calculation of depreciation expense for tax purposes involves certain rules and limitations, which are not reflected in the previous example. The example is intended to illustrate the depreciation expense concept as an allocation of the cost of an asset over the asset’s estimated useful life. If more information is needed about depreciation, see any standard financial accounting textbook.
The regular straight-line depreciation method described above may be used for financial accounting purposes and for calculating tax depreciation expense on assets acquired before 1981. The tax depreciation rules for assets acquired after 1980 are described below.
The tax laws for depreciation were changed in the 1980s when the Modified Accelerated Cost Recovery System (MACRS)MACRSModified Accelerated Cost Recovery System is an accelerated depreciation method used for tax purposes. was introduced. It permits faster depreciation (expensing of assets) to encourage investments by business. The MACRS system provides that depreciation expense (for assets other than real estate) be deducted over a period of time and at rates designated in tax law for assets that are grouped in classes. Table 7.1, “Asset Classes and Recovery Periods” below shows the classes of personal property and the recovery period over which they are depreciated.
Taxpayers may use the MACRS depreciation, or may elect to compute depreciation using another accelerated method, or use the straight-line method. IRS Publication 946: How to Depreciate Property, provides extensive guidance and numerous tables of depreciation rates. Most taxpayers elect to depreciate personal property at an accelerated rate and would use Table A-1 in Publication 946. To depreciate personal property at the straight-line rate, Table A-8 is used. Real property must be depreciated at the straight-line rate so Table A-6 is used for rental real property and Table A-7a is used for nonresidential real property. A copy of these four most used depreciation tables are provided for quick reference in Chapter 14, Appendix A: Federal Tax Reference of this text.
Go to Publication 946 and read Chapter 1: Overview of Depreciation and Chapter 4: Figuring Depreciation Under MACRS.
Table 7.1. Asset Classes and Recovery Periods
Under the MACRS system, depreciation is calculated by using the correct table, which contains a percentage rate for each year of the property’s recovery period. The yearly rate is applied to the cost of the asset. The cost of the property to which the rate is applied is not reduced for the estimated salvage value or prior years’ depreciation.
For personal property (all property except real estate) acquired after 1986, the percentages in Table A-1 are used as shown in the following example.
Assume a taxpayer acquires an asset (5-year class property) in 2009 with a cost basis of $19,000 and uses accelerated depreciation under MACRS. The depreciation expense deduction for each year of the asset’s life is calculated (using the percentages in Table A-1) as follows:
In the above example, note that even though the asset is 5-year class property, the cost is written off over a period of six tax years. This is due to the convention under MACRS, which provides for six months of depreciation during the year the asset is purchased and six months of depreciation in the final year. This is the “half-year convention.”
For property (other than real estate) acquired after 1986, a taxpayer may elect to use straight-line depreciation instead of the accelerated depreciation rates under MACRS. Table A-8 in Publication 946 uses the half-year convention, straight-line method with no salvage value.
Cheri uses a computer for use in her business. The computer cost $19,000 and Cheri elects to use straight-line depreciation over five years instead of accelerated depreciation under MACRS. The annual deduction for depreciation over the life of the computer is calculated below (the percentages are taken from Table A-8).
Cheri deducts six months depreciation in the year of purchase, even though the asset was put into service on April 1. On the other hand, if the asset had been placed in service on September 1, Cheri still would have received a deduction for six months of depreciation
Under MACRS, the same method of depreciation (accelerated or straight-line) must be used for all property in a given class placed in service during that year.
When a taxpayer acquires a significant amount of assets during the last quarter of the tax year, the half-year convention, referred to in the above examples, may be replaced with a mid-quarter convention. The mid-quarter convention must be applied if more than 40% of a taxpayer’s property acquired during the year, other than real property, is placed in service during the last three months of the tax year. The mid-quarter convention treats all property placed in service during any quarter of the tax year as being placed in service on the mid-point of the quarter. The mid-quarter convention, if applied in the year the asset is acquired, also applies upon the disposition of the asset. Assets placed in service and disposed of during the same tax year are not considered in determining whether the taxpayer meets the 40% test. Tables A-2, A-3, A-4, and A-5 in Publication 946 list the mid-quarter depreciation rates by class of property.
Bella buys the following property during 2009 for business use:
The cost of the automobile acquired during the last three months of the year represents 86% of the total cost of assets, other than real property, acquired during the tax year. Since more than 40% of Bella’s purchases, other than real property, were made during the last three months of the tax year, the mid-quarter convention would apply and Tables A-5 would be used to calculate depreciation expense for both the office furniture and the automobile acquired during 2009.
For real estate acquired after 1986, MACRS requires the property to be depreciated using the straight-line method. The straight-line MACRS realty tables for residential realty (e.g., an apartment building) provide for depreciation over 27.5 years. Nonresidential realty (e.g., an office building) is depreciated over 39 years (31.5 years for realty acquired generally before May 13, 1993). The annual depreciation percentages for real estate under MACRS are shown in Table A-6 (27.5-year property) and Table A-7a (for 39-year property) in Publication 946.
Heidi buys a rental house on September 3, 2009, for $180,000 (the land is accounted for separately). The annual depreciation expense deduction under MACRS for each of the first four years is illustrated below (the percentages are taken from Table A-6).
Note that the percentages are taken from Table A-6 under column 9, because the month of acquisition (September) is the ninth month of the year.
For the depreciation of real property under MACRS, a mid-month convention replaces the half-year convention. Real estate is treated as placed in service in the middle of the month of acquisition. Likewise, a disposition during a month is treated as occurring on the mid-point of such month. For example, under the mid-month convention, an asset purchased and placed in service on April 2 is treated as being placed in service on April 15. The mid-month convention is built into the rates in Table A-6.
For real property purchased prior to 1981 a regular depreciation method is used. For real property purchased after 1980 but before 1987, special depreciation rates and class lives are used. Refer to IRS Publication 534 if depreciating real property purchased prior to 1987.
Depreciation expense is reported on Form 4562, Depreciation and Amortization. Individual taxpayers who have no current year asset additions and who are not reporting depreciation on listed property are not required to file Form 4562 with their return.
Election to expense (section 179 deduction). Taxpayers may elect to expense an amount of the acquisition cost of certain property. This cost would otherwise have to be deducted over a period of time using the regular depreciation rules. To qualify, the property must be personal property (property other than real estate) placed in service during the year and used in a trade or business. The maximum cost that may be expensed in the year of acquisition is $250,000 for 2009 and is subject to the following two limitations.
 This is an increase from $125,000 allowable in 2007 and is part of the Economic Stimulus Act of 2008.
During 2009, Ingrid buys new equipment for her business, which cost $348,000. The first $250,000 of the cost may be expensed in 2009, and the remaining $98,000 may be depreciated over the equipment’s recovery period.
During 2009, Irene buys equipment for business use. The machinery cost $820,000. Irene has business taxable income of $235,000. Since the $250,000 maximum annual limitation is reduced by the cost of assets in excess of $800,000, $230,000 of the cost of the equipment may be expensed in 2009. Since Irene’s taxable income, before considering the election to expense, is $235,000, the second limitation does not apply. However, if Irene had taxable income of only $90,000 after depreciation but before considering the election to expense, the maximum amount that could be expensed would be further limited to $90,000 and the remaining $140,000 ($230,000 − 90,000) is carried over to succeeding tax years.
A taxpayer who has made the election to expense must reduce the basis of the asset by the amount expensed before calculating regular MACRS depreciation on the remaining cost of the asset. Even if the taxpayer is not able to deduct the full amount expensed in the current year due to the taxable income limitation, the basis must be reduced by the full amount of the expense election.
On August 1, 2009, Jim buys a new machine for his business, which costs $260,000 and qualifies as 5-year MACRS property. His business income is $300,000. Jim first claims the full $250,000 deduction under section 179. Jim then claims regular MACRS depreciation on the machine of $2,000 = ($260,000 − 250,000) × 20%. Jim’s total first year section 179 and depreciation deductions are $250,000 + $2,000 = $252,000.
When calculating depreciation on an asset when an election to expense only part of the asset has been made, the amount of the section 179 election to expense must be decided upon first. When a taxpayer decides to take only a portion of the cost of the asset as a section 179 deduction, the rest of the cost of the asset must be depreciated. The depreciation must be deducted from taxable income to determine the income limitation for the section 179 deduction.
Joel’s taxable income from his sole proprietorship before depreciation is $30,000. He bought a $60,000 machine during the year. He elects to “expense” $30,000 of the machine under section 179. The remaining $30,000 cost of the machine is depreciated over a 5-year life. The depreciation is $30,000 × 20% or $6,000. Joel’s taxable income after depreciation is $30,000 − $6,000, or $24,000. Only $24,000 of the election to expense can be used in the current year, bringing his income down to zero, and $6,000 will be carried forward to the next year subject to the income limitation again and he will also be able to depreciate the $30,000 not elected as expense under section 179 for the second year and following years until the $30,000 is fully depreciated.
Special depreciation allowances for certain property. The Economic Stimulus Act of 2008 provided stimulus credits to taxpayers but also contained provisions to encourage businesses to purchase more capital goods and equipment by instituting a bonus first-year depreciation. The bonus is an additional deduction of 50% of the property’s depreciable basis after any section 179 deduction and before figuring the regular depreciation deduction. The property that qualifies for the special depreciation allowance includes tangible property depreciated under MACRS with a recovery period of twenty years or less, water utility property, off-the-shelf computer software, and qualified leasehold improvement property. The property must have been acquired by purchase after December 31, 2007, and before January 1, 2010.
Jerry bought office equipment that cost $17,000 in March 2009. He elects to deduct the 50% bonus depreciation in addition to the regular MACRS depreciation for the year. The depreciation deduction for 2009 is $9,715. The bonus depreciation of $8,500 = $17,000 × 50% is added to the regular depreciation of $1,215 = ($17,000 − 8,500 bonus depreciation) × 14.29% the first-year rate on 7 year property (from Publication 946 Table A-1).
Joan bought new computer equipment for her business in April 2009. The equipment cost $81,000 and she elects to deduct $21,000 under section 179 and the 50% bonus depreciation in addition to the regular MACRS depreciation for the year. Joan’s depreciation deduction for 2009 is $57,000 computed as follows.
$21,000 under section 179
+ $30,000 bonus depreciation = 50% × ($81,000 − 21,000)
+ $6,000 = 20% × ($81,000 − 21,000 − 30,000)
Listed property depreciation. Congress felt some taxpayers were using the favorable tax incentives of the accelerated depreciation and the immediate expensing election to claim depreciation deductions on assets used for personal purposes. To reduce this perceived abuse, Congress enacted special rules that apply to the depreciation of “listed property.” Listed property includes those types of assets that lend themselves to personal use, including the following:
If listed property is used 50% or less in a qualified business use, any depreciation deduction must be calculated using the straight-line method of depreciation over an alternate recovery period, and the special election to expense is not allowed. Qualified business use does not include investment use or the use of property by an employee in performing services as an employee, unless the use meets the convenience of-employer and condition-of-employment tests. In addition, the excess depreciation allowed by reason of the property meeting the more-than-50-percent-use test must be included in income if property, which meets the test in one year subsequently fails to meet the more-than-50-percent test in a succeeding year.
Josh uses a personal computer at home to manage his investments. The computer is listed property. Depreciation must be calculated using the straight-line method over an alternate recovery period.
Karl uses a personal computer at home 30% of the time to manage his investments and 65% of the time in his business. Since Karl’s business-use percentage exceeds 50% (65%), he is not required to use the straight-line method in calculating depreciation. The accelerated depreciation method and the election to expense may be used. In determining the total depreciation expense for the year, Karl will consider the combined business and investment use of 95%, with the 65% being deducted on Schedule C and 30% being deducted as a miscellaneous itemized deduction subject to the 2% AGI limitation.
“Luxury” automobile depreciation. In addition to the limitations on the depreciation of passenger automobiles imposed by the listed property rules discussed in the preceding section, the depreciation of passenger automobiles is subject to an additional limitation, commonly referred to as the luxury automobile limitationluxury automobile depreciation limitLimit on the amount of depreciation deduction on automobiles; while called “luxury” it applies to all dollar values of autos.. Regardless of the method of depreciation used by the taxpayer, accelerated or straight-line, or the election to expense, the amount of depreciation expense that may be claimed on a passenger automobile is subject to an annual dollar limitation. If the taxpayer wants to use the section 179 deduction, the limitation applies to the deduction plus depreciation expense. The annual dollar limitations that apply to passenger automobiles are listed in Table 7.2, “Annual Automobile Depreciation Limitations”. Any automobile that would have actual MACRS depreciation exceeding the stated limits is considered a “luxury” automobile by the IRS for purposes of the depreciation limitation rules.
Table 7.2. Annual Automobile Depreciation Limitations
Bonus depreciation is also available for vehicles that qualify under the 50% special depreciation allowance provisions. The maximum bonus depreciation that can be deducted for all vehicles in 2009 is $8,000. In computing the amount that can be deducted, the section 179 portion is deducted from the depreciable basis first, then the 50% bonus depreciation, and then the annual depreciation percentage. The annual limitations must be reduced to reflect the actual business-use percentage where business use is less than 100%.
Kolby bought a new car for $39,000 in February 2009, which he uses 90% for business. He opts to deduct the special 50% depreciation for the year in addition to the regular allowed depreciation. For 2009, Kobly can deduct:
$17,550 = $35,100 [depreciable basis ($39,000 × 90% business use)] × 50% bonus depreciation
$3,510 = $17,550 × 20% (MACRS rate for 5-year property)
$21,060 = $17,550 + $3,510 but this amount is limited to:
$10,960 = $8,000 special 50% + $2,960 first-year depreciation limit on automobiles; but limited to 90% business use = $10,960 × 90% = $9,864
Kellin bought an automobile that cost $30,000 in August 2009, which she uses 40% for business and 60% for personal purposes. Since the greater-than-50% test is not met, Kellin must use straight-line depreciation. In addition, depreciation expense cannot exceed the annual dollar limitation multiplied by the business-use percentage, $2,960 × 40% = $1,184.
Kevin bought a $32,610 passenger automobile in September 2009, which he uses 100% for business purposes. The MACRS depreciation normally computed and the annual limits are shown below for Kevin’s car.
Note that, although the automobile is 5-year property, it will take 11 years to recover the entire cost of the asset because of the annual dollar limits.
Go to Publication 946, Chapter 5 and read from the beginning of the chapter through the section: Maximum Depreciation Deduction.
Taxpayers who lease vehicles have the option of using the standard mileage method or actual costs in computing the cost of business transportation. With a lease there is no depreciation deduction when computing actual costs but there is a lease expense amount. Leased passenger automobiles require that a taxpayer report an “inclusion amount” in gross income. The inclusion amount is computed from an IRS table for each taxable year that a taxpayer leases an automobile. The purpose of the inclusion is to prevent taxpayers from circumventing the annual depreciation limitations placed on owned automobiles.
 The “inclusion amount” is not included in gross income but is a reduction of the claimed lease expense. See Publication 463: Travel, Entertainment, Gift and Car Expenses for more information and the Inclusion Amount tables.
The dollar amount of the inclusion is based on the fair market value of the automobile and is prorated for the number of days the automobile is used during the tax year. The prorated dollar amount is then multiplied by the business percentage use of the automobile to determine what the gross income inclusion should be. The net effect is that the lease payment deduction is reduced by the inclusion amount.
On April 1, 2009, Mark leases a car worth $40,000 for a 5-year period. In 2009 and 2010, Mark uses the car 70% of the time for business purposes. Assuming the IRS table amount for 2009 is $161 and for 2010 is $353, Mark must prorate the expense to the time period of the lease in 2009 and reduce the lease payment expenses by the following amounts (note that the inclusion amounts in this example are hypothetical; refer to Publication 463 for the current rates).
2009: $85 = $161 × (275/366) × 70%
2010: $247 = $353 × (365/365) × 70%
Amortization of intangibles. Over the years, tax treatment of intangible assets has been controversial. The major issues were (1) whether or not an intangible asset existed, (2) the value of the intangible asset, and (3) the proper recovery period. The Revenue Reconciliation Act of 1993 created a new statutory tax provision for many intangible assets called “section 197 intangibles.” Section 197 intangibles are amortized over a 15-year period, beginning with the month of acquisition. The 15-year life applies despite the actual estimated useful life of the intangible asset. No other amortization or depreciation method may be claimed on section 197 assets. The following are defined as section 197 intangibles:
 Tangible assets like automobiles, buildings, etc. are depreciated. Intangible assets are amortized, which is the allocation of cost over the life of the asset, just like depreciation.
One major change of this law was to make goodwill and going-concern values amortizable. Prior to the enactment of section 197, the amortization of goodwill and going-concern value was not allowed for tax purposes. Goodwill is defined as the value of a trade or business attributable to the expectation of continued customer patronage. Going-concern is the additional value attached to property because it is an integral part of a going concern.
In March, Laura buys a business for $300,000. Section 197 goodwill of $50,000 is included in the purchase price. Laura amortizes the goodwill over a 15-year period at the rate of $277.78 per month, starting with the month of purchase.
Many intangible assets are specifically excluded from the definition of section 197 intangibles and are amortized on a straight-line basis over varying time periods. Examples of these section 197 exclusions include:
Lea buys computer software sold to the general public for $32,000. The $32,000 is not a section 197 intangible and therefore it would be amortized under regular amortization rules (typically three years).
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