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.
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:
- 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.
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 mid-quarter 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.
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).
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:
- Will your business income increase, making depreciation deductions desirable in the future?
- 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.