When property is used in a business and expected to last longer than one year, but will eventually wear out or become useless:

− It cannot be expensed in the year that it was put into use

− The cost must be spread out over its expected life with a portion of the cost being deducted each year

The cost of most real and personal property used for business or for the production of income can be recovered through depreciation.

Depreciation is an amount that can be deducted annually.

It allows the taxpayer to recover the cost or other basis of certain property over the time the property is used in trade or business.

Lesson I: Depreciation

IRS Publication 946

Eligible Property

To be depreciable:Property must be owned by the taxpayer Property must lose its value over time from any of the following:

– Wear and tear– Deterioration– Obsolescence– Natural causes

•Property that does not wear out (such as land) cannot be depreciated.

Eligible Property (Cont.)

Depreciation is a business expense deduction.

Property used exclusively for personal activities, or to generate non-taxable income, is not depreciable.

Property that is placed in service and disposed of in the same year is also not depreciable.

Any addition or improvement made to depreciable property is treated as a separate depreciable property.

• Tanya completely replaced the roof of a rental property she owns.

• The new roof is an improvement and, for tax purposes, is a different asset from the building.

• Tanya must depreciate the cost of the new roof separately from the building.

Note: Repairs and maintenance costs are not depreciated.

Replacement of small items, such as a faucet or a switch, are considered maintenance.

Depreciation Example

Basis

Cost basis of property = Cost + Taxes, Delivery, or setup or installation charges

Adjusted Basis

• When an asset’s cost basis is adjusted by some event, such as an improvement, the updated basis is known as adjusted basis.

• When an asset is converted from personal use to business use, its basis is the lower of either the:

– Cost

– Fair market value (FMV) at the time of conversion

Bobbie bought a townhome four years ago.

The purchase price was $75,000, which includes a land value of $10,000.

This year, Bobbie moved and decided she would use her townhome as rental property.

When she began renting the townhome it had an FMV of $120,000, which includes a land value of $15,000.

Bobbie’s adjusted basis for depreciation on the rental townhome is $65,000, which is the lower of the home’s original cost or the FMV at the time she converted its use.

Because land does not wear out, it is not considered in the basis for purposes of depreciation.

Adjusted Basis Example

Allowed or Allowable Depreciation

The taxpayer’s basis in an asset is reduced annually by the greater of:

•Allowed Depreciation

The amount the taxpayer actually took

•Allowable Depreciation

The amount the taxpayer could have taken under the depreciation rules

Note: When the taxpayer disposes of the depreciable property, they are required to recapture the allowable depreciation even if they did not claim it during the life of the asset.

But they must depreciate property when it falls into a category when depreciation is expected.

Allowed or Allowable Depreciation Example

Alice paid $2,000 for a machine to use in her business.

The total allowable depreciation was $776.

But she did not actually claim the depreciation.

The adjusted basis for calculating her gain or loss if she sells the machine is $1,224.

Fully Recovered Basis

Property is generally considered fully depreciated when the total amount depreciated equals the adjusted basis of the property.

Once the property has been fully depreciated, no more depreciation is allowed even the taxpayer still uses the property.

When Depreciation Begins and Ends

Depreciation begins when the taxpayer first places the property in service for a business or for the production of income.

Property is placed in service when it is ready and available for a specific use.

It does not matter that the property is not yet being used for the intended purpose.

When Depreciation Begins and Ends Example

• Callie bought a key-making machine for her hardware store.

• She ordered it on May 1.

• It was delivered on June 16 and installed on July 7.

• Callie made her first key on September 4.

• The date the key machine was placed in service is July 7, which is the date it was ready and available for its intended purpose.

• The fact that Callie did not use it until September does not affect the date the machine was placed in service.

Property Temporarily Idle

Once the taxpayer has begun depreciating property, they continue to claim depreciation on the property even if it is temporarily idle.

Example: If Frank stops using a machine because there is a temporary lack of market for a product made with that machine, he continues to deduct depreciation on it.

Depreciation End Time

• Once the taxpayer has fully recovered their basis, or the property is no longer used in business, depreciation ends.

• Depreciation also ends when the taxpayer stops using the property because they retire it.

• Property is considered retired when the taxpayer stops using it entirely in their trade or business because it has been:

– Sold

– Exchanged or destroyed

– Changed to personal use

– Abandoned

– Transferred to a supply or scrap account

Lesson II: MACRS

IRS Publication 946

Modified Accelerated Cost Recovery System (MACRS) is the cost recovery system used to depreciate most property.

Under MACRS, an asset is classified according to its property type and the period of time over which the cost can be recovered.

The recovery period depends on the depreciation system the taxpayer chooses.

A recovery period is a predetermined number of years in which the cost or the other basis of the property is recovered.

Depreciation Systems

MACRS consists of two depreciation systems:

1. General Depreciation System (GDS)

2. Alternative Depreciation System (ADS)

GDS

Faster of the two depreciation systems under MACRS

Methods for calculating depreciation:

200% declining balance

150% declining balance

Straight line methods

ADS

Slower of the two depreciation systems under MACRS

Method for calculating depreciation: straight line

GDS

• GDS is the default system used under MACRS, and is sometimes referred to as regular MACRS.

• GDS accelerates the recovery of an asset’s cost by taking greater deductions in early years, and uses the shortest recovery period allowable.

ADS

• ADS applies straight-line depreciation, in which an equal amount of an asset’s cost is deducted each full year over its useful life.

• ADS recovery periods can be longer than regular MACRS recovery periods.

• Using the ADS method is an election for most properties, but is mandatory in some situations.

Class Life

• The IRS groups similar assets into classes according to the type of property.

• Each class is assigned a class life, which is the average number of years the property is expected to be functional and useful.

• Taxpayers must use the IRS estimates of an asset’s class life.

Property Classes• Under regular MACRS, assets

are assigned to one of nine property classes.

• The property class generally determines:

– Depreciation method

– Recovery period

– Convention

• A convention is a method established under MACRS to determine when the recovery period begins and ends.

• The convention affects a taxpayer’s depreciation deduction for the year they place the property in service and for the year they dispose of it.

Half-Year Convention

The half-year (HY) convention is the most common.

All property placed into service during the year is considered to be placed at the midpoint of the year, regardless of when it was actually placed into service.

For the first year that the property was placed into service, only half of the yearly depreciation is taken when the property is disposed of, no matter how long the property was actually used during the first and last year.

Half-Year Convention Example Latisha purchased a new over-the-

road tractor for her independent trucking business on March 10 of this year.

This asset has a property class of three years and a recovery period of three years under GDS.

Since Latisha is using the half-year convention for this asset, she depreciates it for 6 months in the first year of ownership even though she placed it in service for more than 8 months.

She does not lose the extra 2 months of depreciation because in the final year of depreciation the tractor will again be depreciated for 6 months.

Note: Use the half-year convention when no other convention is required.

Mid-Quarter Convention

The mid-quarter (MQ) convention must be used when 40% or more of depreciable property is placed into service during the last quarter of the tax year.

This does not include residential rental property or non-residential real property.

For example:

Let’s say Latisha’s tractor had a depreciable basis of $50,000.

In addition to purchasing the tractor in March, she also placed into service three additional tractors for $30,000 each in November of the same year.

The total amount of depreciable assets placed into service in the same year is 110,000 with 55% of the assets, 60,000 of the 110, placed into service during the last quarter of the year.

In this case, Latisha would have to use the mid-quarter convention for all property placed into service for the entire year; all four tractors. Not just those placed into service during the last quarter.

Note: A calendar year is divided into quarters, as shown in the graphic.

Mid-Quarter Convention

(continued) When the mid-quarter convention is

required, it must be used for all property placed in service during the year.

There are different depreciation percentage tables for each quarter.

Under the mid-quarter convention, all property placed in service or disposed of during any quarter of a tax year is treated as placed in service or disposed of at the midpoint of the quarter.

This means that 1 ½ months of depreciation for the quarter the asset was placed into service would be allowed the first year and 1 ½ months for the year it was disposed of would be allowed.

There are certain property classes that allow specific conventions to be used.

The two property classes shown in the table that require a specific convention are Residential rental property and Nonresidential real property.

Mid-Month Convention

Residential rental property and nonresidential rental real property require the use of the mid-month (MM) convention.

Under this convention, all property placed in service or disposed of during a month is treated as placed in service or disposed of at the midpoint of the month.

This results in a half-month of depreciation for the month in which the property is placed in service and for the month in which it is disposed of, no matter how many days that month it was actually in service.

Mid-Month Convention Example

Annorah bought a residential rental apartment property for $200,000 on June 19.

The mid-month convention is required for residential rental property.

On July 1, she purchased a refrigerator for $700 for one of the apartments.

On November 9, Annorah purchased three stoves for the property for $1,500.

She placed 68% of her qualified assets in service during the last quarter ($1,500 ÷ [$1,500 + $700]).

Annorah must use the mid-quarter convention for both the refrigerator and the stoves.

The cost of residential rental property is not taken into consideration when determining what percentage of assets was placed in service during the last quarter.

Depreciation Methods

Depreciation is calculated using either a straight-line method or an accelerated method.

Under regular MACRS (GDS), the methods are:

– Straight-line (S/L)

– 200% declining balance (200 DB)

– 150% declining balance (150 DB)

Straight-Line Method

The straight-line method is a method for calculating the depreciation of property that uses a percentage rate to deduct the same amount for each year of the recovery period.

The percentage rate is determined by the number of years in the recovery period.

Under the straight-line method, an equal amount of depreciation is taken each full year during the asset’s useful life.

Declining Balance Methods

Under the declining balance methods, the cost recovery rate of an asset is accelerated.

Under the 200% declining balance method, 200% of the straight-line rate is applied to the remaining depreciable balance of an asset, until the straight-line method results in a larger deduction.

Under the 150% declining balance method, 150% of the straight-line rate is applied to the remaining depreciable balance of an asset.

Accelerated methods result in a higher amount of depreciation in the first few years of use.

2010

2011

2012

The IRS has created depreciation charts (also called percentage tables) that incorporate depreciation methods, and the applicable recovery periods.

These percentages are applied to the beginning basis of the depreciable assets.

The MACRS tables automatically provide for the change to straight-line when it benefits the taxpayer.

Lesson III: Depreciation Calculations

IRS Publication 946

Calculating the Depreciation Deduction

Before depreciation can the calculated, the taxpayer must know their basis.

Basis is usually their cost, plus any improvements to the property before it was placed into service, and decreased by the value of any uninsured casualty losses.

Certain property may be eligible to have part or all of its cost recovered in the year the taxpayer purchased it.

This is known as a Section 179 deduction.

Additional Depreciation Deductions

At times, Congress increases certain benefits to taxpayers to help boost the economy.

To accomplish this, they may increase limitations (such as the Section 179 deduction) or make additional deductions available that allow taxpayers to take advantage of the temporary changes.

One such additional deduction is known as a special depreciation allowance (also known as bonus depreciation or first-year additional depreciation allowance).

This is an additional deduction taxpayers can take before calculating regular depreciation on a new (not used) asset under MACRS, for the first year the property is placed in service.

When determining the basis for depreciation, reduce the original basis by any special depreciation previously claimed.

For qualified property acquired before May 6, 2003, the special depreciation allowance is 30%.

For qualified property acquired after May 5, 2003 and before January 1, 2008, the special depreciation allowance is 50% unless the taxpayer elects to use the 30% allowance.

In 2008, the economic stimulus act eliminated the 30% allowance and made 50% the allowance percentage.

For qualified property acquired after September 8, 2010, the allowance is 100%.

Business Use

Only the portion of the taxpayer’s basis that represents business use is depreciable.

Multiply the basis of the asset by the percentage of business use to determine the depreciable basis.

Business Use Example

Louis purchased a new lawn mower for $800.

He uses it 80% of the time in his lawn care business.

His depreciable basis for business use is $640 ($800 × 0.80).

The taxpayer must maintain records such as a calendar or log book to substantiate the determination of business-use percentage.

The method used must be reasonable and consistent.

Special Depreciation Allowance

For qualified property acquired after September 8, 2010, and placed in service before January 1, 2012, the special depreciation allowance is 100% of the business-use percentage.

This special allowance is based on the depreciable basis of the property after any Section 179 deduction is claimed and before any regular depreciation is taken for the tax year.

The 50% special depreciation allowance cannot alternatively be selected for assets placed in service in 2011.

If the taxpayer elects out of the 100% special depreciation allowance for property acquired after September 8, 2010, and placed in service before January 1, 2012, then the property does not qualify for the 50% special depreciation allowance.

Qualifying Property Property that qualifies under the special depreciation allowance are:

– Tangible property depreciated under MACRS with a recovery period of 20 years or less

– Water utility property

– Off-the-shelf computer software

– Qualified leasehold improvement property (LHI)

The original use of the property must begin with the taxpayer.

The allowance does not apply to the purchase of used assets.

Property that does not qualify includes:

•Property placed in service and disposed of in the same tax year

•Property converted from business use to personal use in the same tax year it is acquired

•Property required to be depreciated under the Alternative Depreciation System (ADS)

•Property included in a class of property for which the taxpayer elected not to claim the special depreciation allowance

Nonqualifying Property

Special Depreciation Allowance Example On May 1, Tom bought

a business desk that cost $7,000 and placed it in service as qualified property.

He does not elect to claim a Section 179 deduction.

The special depreciation allowance is $7,000 (100%), if all other requirements are met.

Depreciation Tables

To determine a property’s depreciation, apply the exact rates (as they appear in the tables) to the property’s basis.

Apply this rate each year. Do not reduce the basis by prior year deprecation when applying the

percentage. Once the tables are used for a property, the taxpayer must continue to use

them for the entire recovery period of the property. Computerized methods of calculating depreciation use rounding techniques

that sometimes result in slightly different amounts from those calculated using the tables.

Depreciation Tables Example

Willis placed a new mechanic’s toolbox in service for his business on May 3.

It was the only asset placed in service during the year and he uses it 100% for business.

His basis in the toolbox is $1,100.

Under regular MACRS, a toolbox is 7-year property and the half-year convention applies.

With a recovery period of seven years, Willis uses the IRS MACRS Percentage Table A-1.

According to this table, the depreciation rate for the year he places the toolbox in service is 14.29%.

Depreciation Tables Example (Cont.)

Willis placed a new mechanic’s toolbox in service for his business on May 3.

It was the only asset placed in service during the year and he uses it 100% for business.

His basis in the toolbox is $1,100.

Under regular MACRS, a toolbox is 7-year property and the half-year convention applies.

With a recovery period of seven years, Willis uses the IRS MACRS Percentage Table A-1.

According to this table, the depreciation rate for the year he places the toolbox in service is 14.29%.

Depreciation Calculation

The total depreciation for this year is $157 ($1,100 × 0.1429).

If Willis had chosen to claim the special depreciation allowance, his total depreciation for the first year would be $1,100.

Depreciation Calculation

The total depreciation for this year is $157 ($1,100 × 0.1429).

If Willis had chosen to claim the special depreciation allowance, his total depreciation for the first year would be $1,100.

Depreciation Worksheet

Taxpayers should keep detailed information about each depreciable asset with their return documents.

This information should include:

− The calculation of the original basis

− Any Section 179 deductions

− Any special allowance deductions

− Each year’s depreciation

A depreciation worksheet or similar document should be used.

Each business or investment activity that the taxpayer has should maintain a worksheet that lists the assets associated with that activity.

Recapture

When an asset is disposed of prior to the end of its depreciable life (recovery period), some of the previously deducted depreciation may need to be recaptured as taxable income.

The taxpayer needs information from the depreciation worksheet to calculate the amount that must be recaptured, and to adjust their basis to determine whether they have a gain or a loss on the disposition.

Illustration One Mabel Johnson bought

office furniture for $10,000 and placed it in service on August 11.

She uses the furniture only for business.

The furniture is the only property she placed in service this year, so the half-year convention applies.

Under regular MACRS (GDS), the furniture is 7-year property.

She uses MACRS Percentage Table A-1.

Illustration One: Depreciation Deduction

Mabel’s basis in the furniture is its cost.

For each year, the basis is multiplied by the percentage for 7-year property provided in Table A-1.

Mabel multiplies her depreciable basis by the first-year percentage to determine her deduction for the year.

Mabel’s depreciation deduction for each year of the recovery period is shown.

Illustration One: Depreciation Worksheet

Mabel’s depreciation deduction for years 1 and 8 of the property’s recovery period are based on a half-year.

Mabel records the current year’s deduction on a depreciation worksheet, as shown.

Preparers should be sure taxpayers understand the requirement to maintain accurate records and the importance of providing their records from previous years to their preparer.

Percentage of Business Use

For some assets, the percentage of business use may change from year to year.

The taxpayer must maintain, as a part of their permanent records, the business-use percentage for each year.

A separate line of the depreciation worksheet can be used when the business percentage changes.

Illustration Two

Briggs Watkins has a laptop computer that he bought two years ago to use in his management consulting business

He has used it each year, as follows:

– First Year - Did not use it for any personal purpose

– Last Year - Used it to take three online courses in photography, his new hobby

– This Year - Took one online photography course

He determined his business-use percentage according to the number of hours he spent working on his courses.

Each year his business-use percentage changes.

A new line is used to track the depreciation on his depreciation worksheet, as shown

Illustration Two (Cont.)

When he purchased the laptop in 2009, he purchased it with a cost of $4,322, which is listed under ‘cost’ on the depreciation worksheet.

His business percentage was 100% so his appreciable basis is $4,322.

With a five-year recovery period and 200db half-year as his method and convention, his percentage according to the tables is 20% so the amount for 2009 is $866.

His second year business percentage was only 84%.

So we take the original depreciable basis of $4,322 multiply it by 84%, and we get the new depreciable basis of $3,630.

We’re using the same recovery period, the same method and convention, the amount recovered in prior years is from 2009, which is $866.

According to the percentage tables, the second year is 32%, which gives the 2010 amount, $1,162.

In year three, he used it 93%.

So we take the depreciable basis of $4,322 and multiply it by 93%, which gives us $4,019.

The amount recovered in prior years is the $866 from 2009 and the $1,162 from 2010.

So our recovered in prior years total now is $2,028.

The percentage rate for the third year is 19.2%.

So the total amount for 2011 is $772.

Lesson IV: Depreciation Reporting

IRS Instructions for Form 4562

Once you have calculated an asset’s depreciation and entered it onto the depreciation worksheet, enter the depreciation on the appropriate form for each asset’s business use.

Enter depreciation for an employee’s assets on Form 2106, Employee Business Expenses.

If the taxpayer is self-employed, enter depreciation related to their business assets on Schedule C, Profit or Loss From Business.

Purpose of Form 4562

If the taxpayer has assets that were placed in service during the current year, Form 4562, Depreciation and Amortization, is also required.

A separate Form 4562 must be completed for each activity.

The activity needs to be identified by entering it next to the taxpayer’s name at the top of the Form 4562.

Each part of the form has a separate purpose, as shown in the graphic.

Regular and ADS MACRS

Most regular and ADS MACRS depreciation is summarized and reported in Form 4562, Part III.

When Form 4562 is required, enter the total depreciation deduction for items placed in service in prior years on Section A, Line 17.

Form 4562, Part III, Section B

Complete Form 4562, Part III, Section B, for assets placed in service during the current year for which the regular MACRS (GDS) system is being used.

For residential rental property and nonresidential real property, enter the month and year the property was placed in service on Section B, Column (b), Line 19h or 19i.

Reporting the Convention and Method

Illustration Three Seth Stuart is self-

employed as a carpenter.

He has several tools that he bought in prior years, and a new circular saw he bought this year.

Because he put assets in service in the current year, Seth must complete Form 4562 to take his depreciation deduction.

Illustration Three: Worksheet

Illustration Three:

Form 4562

Using the information from Illustration Three, Seth Stuart’s depreciation deduction for his carpentry business is entered on his Schedule C, Line 13, as shown.

Illustration Four