Depreciation

Section 167 of the Internal Revenue Code defines "depreciation deduction" as a reasonable allowance for the exhaustion, wear, and tear (including a reasonable allowance for obsolescence)

  1. of property used in a trade or business, or
  2. of property held for the production of income.

Depreciation methods can be separated into two categories: straight-line depreciation and accelerated depreciation. Currently the Internal Revenue Code utilizes both types of depreciation methods.

As a forest owner, you may depreciate most property used on your woodland if you hold your woodland as either a business or as an investment. Property acquired either new or used can be depreciated. Land is never depreciable, however, certain improvements to land such as fences, temporary roads, bridges, and buildings are depreciable. Equipment and machinery such as sawmills, trucks, tractors and power saws are also depreciable. Please see the depreciation calculations in Examples 1, 2, 3, and 4 below.

An asset's basis is the maximum amount of investment in an asset that can be subtracted from income as a capital recovery. The depreciation rules in effect when an asset is placed in service determine the depreciation method to be used during the life of the asset. An asset is placed in service when it is set up and ready for its intended use for a business purpose.

For assets placed in service prior to 1987 the depreciation method that should be used is the Accelerated Cost Recovery System (ACRS). Assets placed in service after 1986 are depreciated under the Modified Accelerated Cost Recovery System (MACRS). You cannot change to MACRS for property placed in service prior to 1987 that is being depreciated under another method such as ACRS.

The primary difference between the two systems is that MACRS specifies longer recovery periods for depreciable assets, which results in slower depreciation than allowed by ACRS. There is a direct correlation between the useful life of an asset and the size of the depreciation deduction in a given year. The longer the useful life the smaller the deduction. And as a general rule, the earlier you can claim a depreciation deduction, the greater its present value.

Modified Accelerated Cost Recovery System (MACRS):

To simplify the depreciation calculation the IRS has developed tables which incorporate the recovery period, depreciation method and the specific conventions to be used in the acquisition and disposition year. Under MACRS an asset's depreciable basis is multiplied by a percentage obtained from one of the IRS tables to determine the depreciation deduction. The tables can be found in IRS Publication 946, How to Depreciate Property.

NOTE: The IRS Tables are in PDF format, if you do not have Adobe Acrobat Reader click here to download it.

In order to decide which table to use you must determine:

  1. Does the property qualify for MACRS treatment?
  2. What is the asset's depreciable basis?
  3. What is the asset's depreciable recovery period?
  4. What is the appropriate first and last year convention?
  5. Is an accelerated or slower cost-recovery method desirable?

(1) Property subject to MACRS:

MACRS applies to new and used tangible depreciable property. Tangible depreciable property includes buildings, land improvements and equipment. Tangible property can be depreciated only if it is used in a trade or business or held for the production of income and has a determinable life. Land, intangible assets, and personal use assets cannot be depreciated under MACRS.

You can depreciate the business basis of a mixed-use asset but not the personal use part. However, when determining the business portion of a mixed use asset you need to consider the "listed property rules." A typical business asset that is not subject to depreciation is inventory. When inventory is sold, its cost basis is subtracted from sales as a deduction for the cost of goods sold.

(2) Assets depreciable basis:

Depreciable basis is the assets original basis for depreciation, less any amount deducted under the Section 179 election and bonus depreciation to expenses assets. An assets basis for depreciation does not have to be reduced by its salvage value. The depreciable basis does not change during an asset's tax life unless additional capital expenditures are made for the asset. The total capital recovered as a depreciation deduction over an asset's useful life can never be more than its depreciable basis.

NOTE: An assets depreciable basis is not the same as the adjusted basis. Adjusted basis refers to the unrecovered capital of an asset at any point in time. An asset's adjusted basis decreases as depreciation deductions are taken.

(3) MACRS recovery period:

Under MACRS, property is assigned a class life that determines the depreciation recovery period. MACRS provides 3, 5, 7, 10, 15 and 20 year recovery periods for property other than real estate. Most personal property is in the 3, 5 or 7 year class. The 10, 15 and 20 year classes generally include land improvements and specialized types of buildings and other property. Residential rental real estate has a 27.5 year recovery period, whereas nonresidential real estate placed in service before May 13, 1993 has a 31.5 year recovery period. The recovery period for nonresidential real estate placed in service after May 12, 1993 is 39 years. If personal property is not listed in a specific asset class or identified with a specific industry it is assigned a 7 year recovery period.

(4) MACRS conventions:

Section 186 of the Internal Revenue Code prescribes the applicable conventions to be used under MACRS: mid-year, mid-month and mid-quarter conventions. All IRS percentage tables specify the convention being used by that particular class life. The exact date of acquisition or disposition is not crucial in making the appropriate allocation.

Mid-year convention - Generally the mid-year convention applies to all classes of property except real estate. The mid-year convention assumes that personal property is placed in service (and disposed of) in the middle of the year. Under this convention, a half-year of depreciation is allowed in both the first and last years of use. As a result, it takes four years to fully depreciate 3-year property, six years to depreciate 5-year property etc.

Mid-month convention - The mid-month convention is used only for real estate. This convention allocates depreciation according to the number of months the real estate is in service. The mid-month convention assumes that real estate is placed in service (and disposed of) in the middle of the month. Therefore, the months of acquisition and disposition are counted only as half months. You are never allowed a full year's depreciation in the year of acquisition or disposition under this convention.

Mid-quarter convention - The mid-quarter convention applies to personal property and assumes that all property is placed in service and disposed of in the middle of the quarter of the year of acquisition and disposition. If more than 40% of the depreciable basis of personal property is placed in service during the last three months of the tax year, you must use the mid-quarter convention. Therefore, it is important to identify those situations in which more than 40% of the personal property was placed in service in the last three months of the year. MACRS percentage tables with the appropriate depreciation percentages for the quarter of acquisition are available for computing the depreciation deduction.

NOTE: If you want to maximize depreciation deductions plan your personal property purchases to avoid making more than 40 percent of such purchases during the last three months of the tax year. In certain situations the Section 179 election can be used to avoid the mid-quarter convention by expensing assets purchased in the fourth quarter.

(5) Depreciation Method Alternatives:

Under current tax laws you have three alternatives for calculating depreciation:

  1. Regular MACRS
  2. Straight-line method over the MACRS recovery period
  3. Straight-line over the Alternative Depreciation System (ADS) recovery period

The decision on which alternative to use will depend on whether you want to maximize or minimize the deduction in the year of acquisition. To maximize the deduction in the year of acquisition use the Section 179 election, bonus depreciation. and regular MACRS for the remaining depreciable basis.

Regular MACRS - Regular MACRS depreciates property in the 3, 5, 7, and 10 year classes using the 200 percent declining balance method with an automatic switch to the straight-line method in the IRS tables. Assets in the 15 and 20 year classes are depreciated using the 150 percent declining balance method. Under MACRS real property is always depreciated using the straight-line method. The MACRS straight-line method uses a 27.5 year recovery period for residential rental real estate and a 39 year recovery period for nonresidential real estate placed in service after May 12, 1993.

Straight line method over the MACRS recovery period - It is possible to depreciate property at a slower rate than the 200-percent declining balance method by making the MACRS straight-line election. Under this method the annual depreciation deduction is calculated by dividing the depreciable basis of the asset by the number of years in the recovery period. The recovery period under the straight line method is the same as under MACRS for the different classes of property.

NOTE: It may be desirable to take the smaller straight-line deduction because of current low income or loss.

Straight line over the ADS recovery period - The alternative depreciation system generally spreads depreciation deductions over longer recovery periods than MACRS. The election to use the ADS is made on a class-by-class, year-by-year basis for property other than real estate. For real estate, ADS is elected on a property-by-property basis in the year of acquisition. If you elect to use ADS, the depreciation deduction is computed using the straight-line method over a longer alternative recovery period. The longer recovery period can be found in the appropriate IRS MACRS class tables. The deductions for the first and last years of an assets recovery period must be calculated using the applicable mid-year, mid-quarter, or mid-month convention.

NOTE: Electing to use ADS may be appropriate in years in which you have low income or losses and the higher MACRS deduction is not needed. Another reason to use ADS is to avoid the alternative minimum tax. If you have large purchases of depreciable assets you may be subject to the alternative minimum tax because of the greater MACRS depreciation deductions.

Depreciation Calculation Examples

Example 1
You spent $3,750 to purchase equipment with a 5-year useful life and used it 80 percent of the time in your timber held to produce income in June, 2017. You may use accelerated depreciation to deduct the $3,000 (80 percent of $3,750) over 5 years. You may deduct $600 (20 percent of $3,000) in the first year, $960 (32 percent of $3,000) in the second year, $576 (19.2 percent of $3,000) for the third year, $346 (11.52 percent of $3,000) for the fourth and fifth years, and $173 (5.76 percent of $3,000) for the sixth year, using the 200 percent declining balance with half-year convention.

Example 2
You purchased a new machine with a 5-year useful life and used it in your timber business in July, 2017. The cost of the machine was $2,000. You may elect to claim $2,000 as a Section 179 deduction, assuming your income derived from your timber business plus your salary and wages are more than the deduction.

Example 3
Assume the same facts in Example 2, you may elect to use the straight-line method to claim a depreciation deduction of $200 (10 percent of $2,000) for the first year and $400 (20 percent of $2,000) for the second year.

Example 4
A new equipment you purchased and placed in service in your timber business in June 2017 costs $10,000. Assuming you did not use Sec. 179 deduction, you could take a special bonus depreciation deduction equal to 50 percent of the purchase price. Your bonus depreciation deduction would be $5,000 (50 percent of $10,000). For eligible property placed in service in 2018, the special bonus depreciation rate is reduced to 40 percent of the cost of qualifying new business property.

For more information on depreciation and depreciation methods please refer to IRS Publication 946.