Working as a financial analyst at a major corporation, my work routinely requires me to create models for business transactions, financial scenarios, and program cost-effectiveness assessments. Many inputs go into these models like cash flow implications and cost recovery structure. For the latter, we use a MACRS depreciation table for calculating tax depreciation.
Many use MACRS depreciation, or the Modified Accelerated Cost Recovery System, to model how an asset will depreciate over time. Because businesses rely on policy certainty to make long-term investment decisions, knowing this treatment has been in place since 1986 has given many the confidence knowing it will continue to provide a reliable source for timing depreciation expense from a tax perspective.
Let’s dive in to explore everything related to MACRS depreciation, including its use, key concepts and terms, the important MACRS depreciation table and depreciation calculators, examples, and how tax reform changed the methodology.
What is Depreciation?
Depreciation is an annual allowance given to a trade or business for exhaustion, wear and tear, and normal obsolescence of assets. An asset’s basis must be reduced by the depreciation allowed (or allowable) for a particular year, even if depreciation was not claimed by the taxpayer for that particular year.
Depreciation also counts as an income tax deduction on most types of tangible property (except land) such as buildings, machinery, vehicles, furniture, and equipment. Likewise, certain intangible property, such as patents, customer lists, copyrights, and computer software qualify for depreciation.
In order for a taxpayer to claim a depreciation deduction for property, it must meet the following requirements:
- Taxpayer must own the property (qualified leasehold improvements made to leased property also qualify for depreciation treatment)
- Taxpayer must use the property in a trade of business which seeks to produce income (if used for personal and business use, may only deduct portion associated with business use)
- Property must have a determinable useful life of one year or more
What is MACRS Depreciation?
MACRS is a favorable policy for taxpayers because it accelerates cost recovery benefits. The method allows the taxpayer to take a larger tax deduction in the early years of an asset’s life and smaller deductions in the later years. Doing so reduces taxable income early in the asset’s life and makes it larger in the future.
In other words, MACRS accelerates the cost recovery (depreciation) of an asset but results in the same net depreciation as you would receive under straight-line depreciation. The taxpayer benefits from MACRS depreciation by having a lower net present value for their tax burden.
MACRS can be defined as a cost recovery method generally used since 1986 for depreciable property other than real estate (e.g., a condo, home, etc.). Congress put MACRS in place under the Tax Reform Act of 1986 and allowed the capitalized cost basis of property to be recovered over specific asset useful life categories, which range from 3 to 39 years in length.
When a taxpayer purchases an asset for a business (e.g., equipment, machinery, computer software, buildings, etc.), the total cost cannot be written off in the first year the asset is placed into service, absent special treatment. The IRS allows the taxpayer to deduct a portion of the asset’s cost over its estimated useful life, or the number of years in which the asset is expected to last.
The two types of MACRS asset classes for property are:
- Real Property (Land and Building) – Real property is defined as land and all items permanently affixed to the land (e.g., buildings, paving, etc.)
- Personal Property (Machinery, Equipment, and Automobiles) – Personal property is all property not classified as real property.
If you need help claiming MACRS depreciation on your tax return, consider hiring a freelancer from Fiverr to assist. This platform provides access to highly-rated tax and accounting professionals who can assist you with taking advantage of MACRS depreciation and other useful tax items to keep more of your business income.
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What is the Straight-Line Depreciation Method?
We have looked at MACRS depreciation, but let’s look at the traditional depreciation method used by companies to record depreciation expense on their books.
The straight-line depreciation method has an asset’s depreciation expense spread evenly over its useful life, thereby decreasing at a straight-line rate. It also incorporates a salvage value, which is the estimated value an owner would receive when selling an asset at the end of its useful life.
As stated before, the salvage value factors into the annual straight-line depreciation expense.
Let’s look at a straight-line depreciation example with a salvage value calculation included.
Straight-Line Depreciation Formula
Before we get into the example, it’s best to understand the straight-line depreciation formula.
Unlike MACRS depreciation, straight-line incorporates the asset salvage value. To calculate the straight-line depreciation expense, use the following formula:
(Book Value of Asset – Salvage Value of Asset) / Useful Life in Years = Annual Straight-Line Depreciation Expense
Straight-Line Depreciation Example
In our example, let’s assume a company purchases an asset worth $12,000 with a 10 year expected useful life. The salvage value is estimated at $2,000.
The straight-line depreciation formula would show $1,000 of book depreciation expense taken each year.
($12,000 asset value – $2,000 salvage value) / 10 years = $1,000 per year of depreciation expense
After 10 years, the unit would only have $2,000 in salvage value and otherwise be a fully depreciated asset from the company’s point of view.
The salvage value estimate varies by asset and can be changed in light of new information. If the salvage value calculation changes, resulting in a higher or lower amount, the straight-line depreciation expense would recalculate from the remainder of the asset’s expected useful life.
However, if no changes present and assuming consistent wear and tear over the asset’s life, straight-line depreciation gives a fair representation of the actual decline in an asset’s value of over time.
What are the Various MACRS Conventions?
For calculating the amount of deduction to take under the MACRS depreciation formula, certain timing conventions must be used when placing an asset into service. In particular, let’s review the MACRS mid-month, mid-quarter, and half-year conventions.
- Mid-Month Convention – Straight-line depreciation which the taxpayer computes only on real property based on the number of months property is in service. The taxpayer takes one half month of depreciation in the month the property is placed in service and one half month of depreciation is taken for the month in which the property is removed from service.
- Mid-Quarter Convention – If more than 40 percent of the depreciable personal property is placed in service in the last quarter of the year, the taxpayer must use the mid-quarter convention.
- Half-Year Convention – In general, a half-year convention applies to personal property, under which such property placed in service or disposed of during a taxable year, is treated as having been in service or disposed of at the midpoint of the year. In other words, if a taxpayer places an asset in-service during the beginning of the year, the appropriate MACRS treatment would still require only a half year of depreciation expense to be taken against taxable income.
Machinery and equipment use the half-year convention unless over 40% of the investment was placed into service in the last quarter of the year in which case the taxpayer uses the mid-quarter convention. For real estate, the taxpayer uses the mid-month convention.
Types of Property and their MACRS Depreciation Schedule
Various types of property have different MACRS depreciation schedules, including:
- 3- Year 200% Class – Asset depreciation range (ADR) midpoints of four years and less. Excludes automobiles and light trucks; includes racehorses more than two years old and other horses more than 12 years old, and special tools.
- 5-Year 200% Class – ADR midpoints of more than 4 years and less than 10 years. Includes automobiles, light trucks, computers, qualifying solar equipment and copiers.
- 7-Year 200% Class – ADR midpoints of 10 years and more, and less than 16 years. Includes office furniture and fixtures, equipment, property with no ADR midpoint no classified elsewhere, and includes railroad track.
- 10-Year 200% Class – ADR midpoints of 16 years and more, and less than 20 years. Includes boats and water transportation equipment.
- 15-Year 150% Class – ADR midpoint of 20 years and more, and less than 25 years. Includes sewage treatment plants, telephone distribution plants, qualified improvement, restaurant and retail property, and comparable equipment use for the two-way exchange of voice and data communications.
- 20-Year 150% Class – ADR midpoint of 25 years and more, other than real property with an ADR midpoint of 27.5 years and more, including sewer pipes.
MACRS Percentage Table Guide
General Depreciation System (GDS)
Alternative Depreciation System (ADS)
For greater detail on the types of property and their MACRS depreciation method, see the IRS depreciation table below. This is a chart recreated from the IRS Pub 946.
|MACRS Percentage Table Guide|
|Chart 1. Use this chart to find the correct percentage table to use for any property other than residential rental and nonresidential real property. Use Chart 2 for residential rental and nonresidential real property.|
|MACRS System||Depreciation Method||Recovery Period||Convention||Class||Month of Quarter Placed in Service||Table|
|GDS||200%||GDS/3, 5, 7, 10 (Nonfarm)||Half-Year||3, 5, 7, 10||Any||A-1|
|GDS||200%||GDS/3, 5, 7, 10 (Nonfarm)||Mid-Quarter||3, 5, 7, 10||1st Qtr|
|GDS||150%||GDS/3, 5, 7, 10||Half-Year||3, 5, 7, 10||Any||A-14|
|GDS||150%||GDS/3, 5, 7, 10||Mid-Quarter||3, 5, 7, 10||1st Qtr|
|GDS||150%||GDS/15, 20||Half-Year||15 & 20||Any||A-1|
|GDS||150%||GDS/15, 20||Mid-Quarter||15 & 20||1st Qtr|
|Chart 2. Use this chart to find the correct percentage table to use for residential rental and nonresidential real property. Use Chart 1 for all other property.|
|MACRS System||Depreciation Method||Convention||Convention||Class||Month of Quarter Placed in Service||Table|
Below, you will also Table A-7, Nonresidential Real Property with Mid-Month Convention and Straight-Line Depreciation over 31.5 years.
|Table A-7.||Nonresidential Real Property; Mid-Month Convention; Straight-Line - 31.5 Years|
How is MACRS Depreciation Calculated?
As shown above, there are two sub-systems of MACRS: the general depreciation system (GDS) and alternate depreciation system (ADS). These schedules are both presented above but GDS acts as the most relevant system and is used by businesses for most assets in which they claim MACRS depreciation.
MACRS Depreciation Formulas
|Depreciation Taken in First Year w/MACRS=|
|Asset Cost ×||1||× A × Depreciation Convention|
|Depreciation Taken in Subsequent Years =|
|(Asset Cost − Depreciation Taken in Previous Years) ×||1||× A|
In the above formulas, “A” can equal 100%, 150% or 200% depending on the convention used.
When calculating the depreciation expense using the above MACRS depreciation formulas, you should then compare these to the straight-line depreciation expense from the formula shown above. Over time, the amount of depreciation taken using the MACRS depreciation formula will drop below that of straight-line depreciation.
When this happens, you should begin taking the straight line depreciation expense for the previous year as the relevant depreciation deduction for the rest of the asset’s recovery period. This will yield a higher level of depreciation expense, thereby lowering taxable income more than maintaining the MACRS depreciation expensing.
Alternatively, IRS depreciation tables provided in the next section below can be used to calculate this expense across all years. Simply select the appropriate property type, depreciation method, and date you placed the asset in-service.
MACRS Depreciation Table for 2018, 2019 and 2020
When looking at the MACRS depreciation table below, each column should have all factors sum to 100.
Before proceeding with the printable MACRS depreciation table, you need to make sure you select the correct depreciation rate table. To do this, you will need to know the following information for the asset in question:
- Type of property being depreciated – Residential rental, nonresidential rental, all other property
- Depreciation method selected – Select from the tables above
- Month or quarter the asset was placed into service
To calculate the depreciation expense using the MACRS formula, you will also need the following information:
- Depreciation system used (GDS or ADS)
- Property classification of the asset
- Cost basis of the asset
- Convention used
- Depreciation method
Taxpayers want to depreciate their assets as quickly as possible because this lowers their taxable income and allows for greater investment potential in their business. This is why when taxpayers buy or sell their businesses and file Form 8594, they are careful how assets are categorized to set them up for a better opportunity to reach financial independence. They want to make sure to maximize the amount of assets which can be classified as shorter-term under the MACRS depreciation schedule.
Doing so guarantees quicker cost recovery. Companies would prefer the assets to fall into the first few columns of the MACRS table below. Combined with other tax deductions, MACRS depreciation can be a valuable tool to lower the taxable income of a taxpayer.
Where applicable, other self-employment tax deductions can reduce taxable income further. Form W-2 employees and 1099 contractors may qualify to take MACRS depreciation against any investments in their own business.
If a taxpayer opts to depreciate property on a straight-line basis instead of MACRS, they may do so. When making this election, the taxpayer may choose the regular recovery period or a longer alternative depreciation system (ADS) recovery period.
What Records Should I Keep for Tax Purposes?
When it comes to tracking your applicable tax deductions for the year, you need to keep accurate records to support your claims. This includes any contracts, title documentation, and all receipts. If you can’t prove the expense came as a result of a business-related activity, your back-up might be insufficient for claiming the tax deduction on your return.
Additionally, for depreciation, you will need to create and save a depreciation schedule for all fixed assets you depreciate as part of your trade or business.
You have two great options for tracking your expenses you plan to claim on your annual tax return:
1. Freshbooks Accounting Software
Accounting software like Freshbooks makes it easy to create depreciation schedules. Further, it also handles the following essential accounting and tax-related tasks necessary for running an efficient business:
- Cash flow tracking
- Financial reporting
- Time tracking
- Financial management
- Invoicing & payments
- Estimates & proposals
- Team management
- Client relationship management
- Project management
Right now, Freshbooks has a limited time offer to purchase the software for 60% off on the first 6 months you use the accounting software if you forego the free 1-month trial. Therefore, if you know Freshbooks is the right choice for your business needs, consider locking in the discounted pricing for your first 6 months and taking advantage of the powerful accounting and business management software.
2. TurboTax + QuickBooks
Book and MACRS Depreciation Calculator (Excel)
Whether you need to understand rental property depreciation, short-lived depreciable assets, or depreciation of assets in other areas, this calculator can handle your needs. Because depreciation is an expense useful for lowering your taxable income, it is best to plan how depreciation will look over the useful life of an asset.
This depreciation calculator includes both MACRS depreciation calculations and straight-line book depreciation calculations. Additionally, I included a row capturing the temporary timing differences between MACRS and book depreciation which will eventually reverse as time passes.
The calculator offers two different views, depending on your needs:
- MACRS Depr. – All Useful Lives tab. This tab allows for you to input your single asset’s value and see how the depreciation would work from a tax and straight-line book perspective for nearly every major useful life. This is a useful view to see how depreciation expense changes with the useful life of an asset.
- MACRS Depr. – Multiple Assets tab. This tab provides more functionality in the event you are making investments across multiple years and will have these assets go into service at different points. If you know the planned sequence of when these assets will close to plant and become eligible for MACRS and book depreciation, you can input those values into the Annual Capital Additions cells at the top of the page (highlighted in yellow). From there, you will need to select the desired MACRS and book depreciable lives from the drop down lists in the box to the left. The depreciation spreadsheet will handle the rest, even showing the temporary timing difference at the bottom of the page.
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Different Timing Conventions for MACRS Depreciation
Now, let’s walk through examples of the various timing conventions used under MACRS. First, we shall begin with the Half-Year Convention.
Half-Year Convention Example
Assume a company started business in Year 1 and purchased office furniture on February 15, Year 3 at a price of $10,000. Further, assume this was the only purchase of assets in the year (reason: avoid possibly applying the MACRS mid-quarter convention rules) and no special depreciation rules apply.
Under the MACRS method, office furniture qualifies as 7-year property. The depreciation expense for Year 3 would be $10,000 * 0.1429 = $1,429 (per MACRS depreciation table, specifically the MACRS 7-year column in the table). The depreciation expense for Year 4 would be $10,000 * 0.2449 = $2,449.
Note the lower MACRS depreciation amount under Year 1 due to the MACRS half-year convention.
Using the same example as above, we can see how these details would fit into the MACRS worksheet used to claim the appropriate MACRS depreciation deduction. As you can see, the office furniture classifies as a 7-year asset and uses the 200% declining balance method with a half-year convention.
The depreciation rate (from the tables) matches with the 0.1429 rate.
The second part of the MACRS worksheet enters the $10,000 cost basis and notes the office equipment will only go used for business purposes. In this situation, Section 179 deductions do not qualify (more discussed on this below) and the total resulting MACRS depreciation deduction amounts to $1,429.
MACRS Depreciation Example (Mid-Month Convention)
After looking at the half-year convention above, let’s also look at the mid-month convention which applies when the asset placed into service qualifies as real estate.
Mid-Month Convention Example
A company places a new office building into service on April 7 of Year 1. The adjusted basis of the office building (land excluded from value) amounts to $100,000.
The company determines the straight-line depreciation for the building by dividing 1 by 39 years (the number of years used for depreciating nonresidential property), resulting in 0.02564. Using this factor, the annual depreciation expense for the company’s office building amounts to $2,564 ($100,000 * 0.02564).
Under the mid-month convention, the taxpayer treats the property as placed in service in the middle of April. Therefore, the building qualified as in-service for 8.5 months of the year, which expressed as a decimal amounts to 0.7083 (8.5 / 12). Multiplying this factor by the original results in a first-ear depreciation expense of $1,816.
In the final year of the building’s useful life, the company will depreciate the final 3.5 months (or 0.2917) of one year’s depreciation expense.
YouTube Video on MACRS Depreciation Accounting System
In the YouTube video above, the narrator walks you through many of the topics discussed in the post above about MACRS depreciation. His high-level overview provides an added understanding of how the elements fit together.
Below, I provide more detail about other MACRS depreciation-related items.
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What is the Section 179 Deduction for 2019?
Each tax year, a taxpayer may deduct as an expense in lieu of depreciation, a fixed amount of depreciable property (e.g., machinery, equipment, computer software, etc.). Under tax reform, the limit for 2018 is $1,000,000 for new or used personal property acquired from an unrelated party.
- The Section 179 deduction reduces dollar-for-dollar on an asset placed in service during the taxable year which exceeds $2,500,000 in value. This amount indexes for inflation.
- Taxpayers cannot take the deduction when a net operating loss exists or if the deduction would create a loss.
- Sport utility vehicles (SUVs) with a gross vehicle weight rating above 6,000 lbs., but no more than 14,000 lbs. qualify for deducting up to $25,000 under the Section 179 deduction.
What is Bonus Depreciation?
After the economic fallout from the Great Recession of 2008, Congress sought a way to incentivize capital investment by accelerating the depreciation schedule for the economy writ-large. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended the Bush tax cuts for an additional 10 years and also allowed companies to claim a 100% depreciation bonus on qualifying capital equipment purchased and placed in service by December 31, 2011.
Congress included an extension of 50% bonus depreciation in 2013 and proceeded to extend it annually, though at a lower 50% of the basis amount while the remaining 50% would be depreciated under the normal MACRS recovery period. By the end of 2015, Congress passed the Protecting Americans from Tax Hikes (PATH) Act of 2015, which included a 5-year extension of bonus depreciation, including a phase-out structured as follows:
- 2015-2017: 50% bonus depreciation
- 2018: 40%
- 2019: 30%
- 2020 and beyond: 0%
The PATH Act not only extended bonus depreciation rules under IRC § 168(k), modified percentages and made other provisions permanent, it also extended bonus retroactively to January 1, 2015 through December 31, 2019.
Until Congress passed this into law, companies did not know how to plan their capital expenditures with full knowledge of how the tax code might treat their depreciation expense.
The recent Tax Cut and Jobs Act had two major impacts on bonus depreciation. The first change increased the bonus depreciation percentage to 100 percent for qualified property acquired and placed in service on or after September 27, 2017 and before January 1, 2023. Assets which fail this test (acquired prior to September 27, 2017 but placed in-service after) would revert to the pre-Tax Cut and Jobs Act phase-out rules listed above.
The second change removed the requirement for passing the original use test, meaning property which was newly constructed. This greatly benefited real estate investors given their ability to apply bonus depreciation to existing assets. Hence, why real estate is one of the best investment vehicles available.
By removing the original use test requirement, this essentially negated the need to use the MACRS depreciation tables for personal property assets. By allowing used property acquired after September 27, 2017 to qualify for this special treatment, it can also qualify for bonus depreciation when assessed using a proper cost segregation study (discussed below).
How do State Laws Treat Bonus Depreciation and the Section 179 Deduction?
Despite the Internal Revenue Code being a national convention, individual states can have laws which allow for non-conformity with Bonus Depreciation and Section 179 rules. According to Bloomberg, 25 and Washington, D.C. did not conform with bonus depreciation rules while 14 states and Washington, D.C. did not conform with Section 179 rules.
Some states conform with one or the other, or both. Be sure to check that list for differing Bonus Depreciation and Section 179 amounts. Be sure to review the state-by-state breakout of state conformity with these depreciation provisions.
What is Basis from a Tax Perspective?
Basis is the amount paid for an asset plus other related costs to acquire the asset, such as sales tax, shipping, and installation, less depreciation taken. The basis will change over time and is used to figure the gain or loss upon asset disposal.
For example, if a taxpayer purchases a piece of equipment to be used in a business and it costs $50,000 but has $5,000 in shipping and installation costs and $3,500 in sales tax. The property’s basis is $58,500 ($50,000 + $5,000 + $3,500).
When a taxpayer depreciates the property and adjusts the basis downward, this asset has a lower adjusted basis or tax basis of the asset. As time passes, the adjusted basis will continue to decline unless an improvement is made to the asset.
If an improvement occurs to an asset, the amount must be capitalized if it results in a betterment to the asset. The same occurs for when an asset adapts to a new or difference use or results in a restoration of the asset.
What is the Accelerated Cost Recovery System (ACRS)?
The Accelerated Cost Recovery System (ACRS) was a U.S. federal tax depreciation methodology put in place from 1981 to 1986. The Economic Recovery Tax Act of 1981 included the ACRS system which depreciated assets on shorter depreciation schedules based on cost recovery.
This system increased deductions for property owners under the auspice of priming economic growth.
What is the Difference Between ACRS vs. MACRS?
The primary difference between ACRS vs. MACRS is the latter method uses longer recovery periods for cost recovery. This reduces the annual depreciation deductions used for residential and non-residential real estate.
ACRS assigned assets to one of eight recovery classes which ranged from 3 to 19 years in length. These recovery classes determined the depreciable basis for the assets. ACRS, much like MACRS, aimed to increase the tax deduction taken for depreciation expense and thus increase the cash flow available to those making investments.
Congress eventually saw the rapid depreciation companies took under ACRS and saw the distortion which occurred between cash flow and reported earnings. Because cash flow bears important scrutiny when evaluating a business, it is important not to have the metric distorted by accounting conventions.
MACRS succeeded ACRS as part of the 1986 Tax Reform Act. MACRS uses two different depreciation methods, called the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). Most types of property qualify for GDS, while ADS only applies to certain types of property, which share business and personal use, are used predominantly outside the U.S., or for tax-exempt purposes. Also, the taxpayer could opt to use the ADS if so desired.
How does MACRS vs. Straight-Line Compare?
The MACRS convention is a rigid set of tax rules which allow a certain amount of tax depreciation depending on the asset classification assigned to property. These rates do not necessarily apply to the actual usage or useful life of the property.
Book depreciation, typically straight-line depreciation, adheres more closely with actual usage of the property. Such examples of book depreciation used by taxpayers include straight-line depreciation or unit depreciation. The latter assigns a depreciation amount per unit produced and has depreciation expense incurred based on the use of the equipment or supporting property.
In most cases, the allowable depreciation taken on MACRS property results in the same total depreciation as GAAP or IFRS depreciation. This means the differences between MACRS and book depreciation are considered temporary differences which eventually reverse to even out.
Due to these temporary differences, taxpayers must maintain separate records for both types of depreciation to ensure accuracy.
What is MACRS 200% Declining Balance (Double-Declining Balance Method of Depreciation)?
The MACRS 200% declining balance method of depreciation, also known as the double declining balance method, is a form of accelerated depreciation.
When compared to the straight-line depreciation method, the 200% declining balance method results in more depreciation expense early in the asset’s useful life and less in the later years. The total depreciation taken remains the same between the two methods.
The word “200%” implies the depreciation expense taken is double what you would see under straight line depreciation, while the “declining balance” refers to the asset’s book value at the beginning of the accounting period. To understand this better, let’s look at a 200% declining balance depreciation example.
200% Declining Balance Example
Let’s assume a manufacturer purchases a piece of equipment worth $10,000 on the first day of the year. The manufacturer expects no salvage value (the remaining value of the asset after it has been fully depreciated) at the end of the asset’s useful life in five years.
Under the straight-line method, the annual depreciation would $2,000 (20% * $10,000). Under 200% declining balance, the first year’s depreciation would double to $4,000 (20% * 2). In year 2, straight-line depreciation would again have $2,000 in depreciation expense while 200% declining balance would have $2,400 ($6,000 remaining depreciable basis * 40%).
In year 3, $2,000 again for straight line and $1,440 for 200% declining ($3,600 * 40%). When the annual depreciation under 200% declining balance becomes less than the annual depreciation under straight-line, companies usually switch to straight-line.
What Other Requirements Must a Taxpayer Meet to Claim Depreciation Expense?
Depreciation treatment begins when a taxpayer places property in service for use in a trade or business. When the property has fully recovered (or expensed) its cost or retires from service (whichever comes first), the property ceases to be considered a depreciable asset absent capital improvement or a change in service application.
Also, a taxpayer must identify the following items to ensure the proper depreciation treatment for the property:
- Depreciation method for the property (e.g., straight-line, 200% declining balance, etc.)
- Class life of the asset (e.g., 3, 5, 7, 10, 15, 20, 27.5, or 39-year)
- Determination if property is considered “Listed Property”
- Election of taxpayer to expense any portion of the asset
- “Bonus depreciation” taken in first year of asset life
- Depreciable basis for the property
The Modified Accelerated Cost Recovery System (MACRS) is the proper depreciation method for most property. A taxpayer must use Form 4562, Depreciation and Amortization, to report depreciation on a tax return.
If you need help understanding the necessary components you must meet in order to claim MACRS depreciation on your business property, consider hiring a highly-rated freelancer from Fiverr. These tax and accounting professionals can assist with navigating this useful tax deduction to keep more of your business income.
How did Tax Reform Change the Rules and Limitations for Depreciation?
Under tax reform in 2018, a taxpayer may elect to expense the cost of any section 179 property and deduct it in the year the taxpayer places the property in service. The new law increased the maximum one-time section 179 deduction from $500,000 to $1,000,000.
Further, tax reform increased the phase-out threshold from $2,000,000 to $2,500,000. Starting in taxable years 2019 onward, these amounts will adjust for inflation.
Depreciation treatment also changed under tax reform to expand the definition of section 179 property to include the following improvements to nonresidential real property:
- Qualified improvement property (anything done to improve the interior of a building), unless attributable to enlargement, elevator/escalator, or internal structural framework
- Roofs, HVAC, fire protection systems, alarm systems and security systems
The new tax law also allows temporary 100 percent expensing for certain business assets, known otherwise as first-year bonus depreciation. Bonus depreciation increased from 50 percent to 100 percent for qualified property acquired and placed into service after September 27, 2017 but before January 1, 2023. See here for a full list of factors which apply to this change.
Also, changes occurred for the treatment of luxury automobiles, certain farm property, and applicable recovery periods for real property. On the final item, the new tax law maintains the 39 year and 27.5 year recovery periods for nonresidential real property and residential rental property, respectively, but also the new law changes items slightly.
The alternative depreciation system recovery period for residential rental property decreased from 40 years to 30.
Finally, qualified leasehold improvement property, restaurant property and qualified retail improvement property are not separately defined and do not have a 15-year recovery period under the new law. These changes affect property placed in service after December 31, 2017.
What is Tax Depreciation?
For businesses, they record book depreciation for tracking asset book values. Companies record this expense on their books to reflect the net book value of the asset (book value less accumulated depreciation). In the case of depreciation from a tax perspective, a separate record-keeping occurs to track accelerated depreciation under the tax code.
By accelerating depreciation, this reduces the amount of taxable income reported by a business. When I model the cost-effectiveness of new products or services offered by my company, I always make sure to include the appropriate MACRS treatment to allow for the optimum cost recovery of investments made for the benefit of customers.
Remember, depreciation is the gradual charging to expense of a fixed asset’s cost over its life. From a tax deferral perspective, charging a cost to expense at once is not bad, but rather, it reduces the amount of taxable income from which the company must pay taxes.
This allows a company to recover its fixed asset investment costs sooner from a tax perspective by reducing their taxable income now. For example, if a company can accelerate depreciation expense for their tax return, they can artificially inflate the expenses incurred and lower their income.
All things being equal, this results in lower tax payments for the company now and larger tax payments later when the accelerated tax depreciation becomes less favorable than straight-line depreciation.
This benefits companies by having the time value of money benefit them, and presumably, from society’s point-of-view, reinvest more capital into the economy.
This consideration makes my projects rely on MACRS certainty as a means for recovering costs quicker and helps the business fund continued investments.
Having this tax advantage built into the tax code reduces the overall costs of asset-intensive projects. This also benefits customers by having lower-cost projects than they otherwise would have under a general depreciation system (GDS).
Stated succinctly, tax depreciation generally results in the rapid recognition of depreciation expense and ability for businesses to invest more, thereby benefiting the economy.
In some circumstances, the law allows the charge off of certain fixed assets as a taxpayer incurs an expense, thereby effectively depreciating the asset entirely in one tax year. This rapid cost recovery benefits taxpayers the most.
What is Accelerated Depreciation and Why Does it Encourage Private Sector Investment?
MACRS depreciation is an important tool for a business to recover capital costs over an asset’s lifetime. Accelerated depreciation results in reducing the amount of taxable income in the immediate future by recognizing increased depreciation expenses sooner.
By virtue of the near-term taxable income decreasing, the taxable income in the later years will be larger to compensate. Said differently, the taxpayer has lower taxable income now in exchange for having higher taxable income later.
This occurs in the future on account of accelerated depreciation resulting in a lower level of expense than straight-line depreciation. Having more cost recovered earlier in the asset’s life makes MACRS depreciation advantageous from the company’s point of view.
Accelerated MACRS depreciation takes advantage of the time value of money. In effect, by reducing the net present value of the amount of taxes you owe, MACRS rates result in more money for companies to invest in their business and conceivably grow for the benefit of the economy.
As an example, in the solar industry, the MACRS solar method calls for businesses to deduct the depreciable basis over five years as opposed to the standard useful life of 20 or even 30 years for solar equipment. Inverters have shorter useful lives, typically half that of the panels themselves, and more closely align with the five year MACRS solar treatment.
Allowing solar companies to use the MACRS 5-year schedule reduces the tax liability in the short-term and accelerates the rate of return on a solar investment. Over the life of the project, the income tax liability remains the same, just at a lower net present value to the business.
This tax depreciation treatment has been a significant driver for the solar industry and related industries. It, along with the solar energy investment tax credit, has helped drive the build out of solar energy across the country. This has gone a significant way toward answering whether solar panels are worth it.
To see how solar companies expense their depreciation for tax purposes, look at the 2018 MACRS depreciation table (up to date to reflect changes from the Tax Cuts and Jobs Act), specifically the MACRS 5-year table column.
How Can Taxpayers Use Cost Segregation Studies to Find Additional Deductions?
According to the American Society of Cost Segregation Professionals, a cost segregation study is the process of identifying property components that are considered “personal property” or “land improvements” under the federal tax code.
In other words, a cost segregation study, also called a “seg” study, looks for and reclassifies personal property assets to shorten the depreciation time for tax purposes. Doing so reduces the current taxable income for a taxpayer.
Technically speaking, a seg study allows a taxpayer who owns real estate to classify certain assets as Section 1245 property with shorter useful lives for depreciation purposes, instead of the useful life assigned for Section 1250 property. These are associated with Section 1231 property.
Examples of personal property reclassified under a seg study include a building’s non-structural elements, exterior land improvements and indirect constructions costs. With a seg study, the taxpayer finds all construction-related costs which can be depreciated over a shorter life (e.g., 5, 7 and 15 years) than the building itself (39 years for non-residential property).
Personal property assets found in a seg study generally include items which are affixed to a building but do not relate to the overall operation of the building.
Land improvements generally include items external to the building which are affixed to the land. By reducing the useful lives of items like parking lots, driveways, paved areas, site utilities, etc., the taxpayer reduces the income subject to taxation.
Recent changes under tax reform in 2018 have given cost segregation a boost when bonus depreciation increased from 50% to 100% on certain qualifying assets. Real estate investors will receive immediate expensing of certain assets with 5, 7, and 15-year MACRS useful lives.
How to Account for Land Improvements
As stated above, land improvements include enhancements to a plot of land in order to make the land more usable for a business purpose. Specifically, if these improvements have a useful life, they should be depreciated as would occur with any depreciable asset.
However, this may entail some difficulty because there may not exist a way to estimate a useful life. In this situation, you do not depreciate the cost of the improvements. On the contrary, in the event the land improvements prepare the property for its intended purpose, then include these expenses in the cost of the land.
In other words, do not depreciate the land improvements, but capitalize them into the cost of land held on the balance sheet. Some common examples of non-depreciable land improvements include:
- Demolishing an existing building
- Clearing, leveling and grading the land
Also, as mentioned prior, land does not depreciate because it has no useful life associated with the property. Rather, land has a perpetual life from an accounting perspective.
The only instance where you would “depreciate” land occurs when the land contains natural resources which are being extracted (and the land is being depleted) from alternative investments like oil and gas resources.
Another instance where you may have accounting repercussions for land improvements comes when you add functionality to the land. When you pursue this action and the investments have a useful life, you must record their costs in a separate Land Improvements account.
Some common examples of land improvements include:
- Drainage and irrigation systems
- Parking lots and walkways
In the event you make depreciable land improvements, building owners can use MACRS to depreciate their costs over a shorter period than 39 or 27.5 years. In fact, these qualified land improvements can be depreciated over 15 years at 150% declining balance, with certain personal property depreciated over 5 or 7 years at 200% declining balance.
To identify these eligible land improvements, you must conduct the analysis discussed above in what is known as a cost segregation study.
What is a Short Tax Year?
A short tax year is any tax year with less than 12 full months. A short tax year can occur in the first or last year of a partnership, corporation, or estate’s existence, or when a taxpayer changes from a fiscal year to a calendar year or vice versa.
Because of this shortening, the MACRS depreciation tables from above cannot be used with these short tax years. To compute depreciation in a short tax year, it will depend on the short tax year conventions (mid-month, half-year, or mid-quarter). Also, even in a short tax year, the full amount of Section 179 expense can be taken against taxable income, subject to normal limits.
Instead of using the MACRS depreciation tables, use the following procedure:
- Determine the short tax year convention for the property as well as the number of months property is in-service. This will provide the midpoint.
- Calculate the full year depreciation by multiplying the depreciable basis by the applicable depreciation rate.
- Multiply the full year depreciation by a fraction comprised of the number of months from Step 1 and the denominator being 12 (months in a year).
Following these steps will prorate the depreciation expense to account for the short tax year.
After a short tax year, you will need to multiply the adjusted basis of the property at the beginning of each tax year by the applicable depreciation rate. If the taxpayer uses the 200% declining balance or 150% declining balance, switch to straight-line in the year the straight-line method yields a higher deduction.
What are the Tangible Property and Disposition Regulations (IRC 263A and 162A)?
Taxpayers who own depreciable assets or who buy, sell, improve or dispose of assets must comply with the tangible property regulations for tax years beginning on or after January 1, 2014. The Tangible Property and Disposition Regulations provide guidance on the application of § 263(a) and § 162(a) to amounts paid to acquire, produce, or improve tangible property.
These regulations provide specific guidance around the treatment of improvements made to property for depreciation purposes.
§ 263A denies a deduction for any amounts paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. It also denies any amount expended to restore property or allowances made for such restoration.
Previously, guidance under § 263(a) provided capital expenditures included amounts paid to add to the value or substantially prolong the useful life of property owned by the taxpayer, or adapt the property to a new or different use.
IRC 263A generally requires direct and allocable indirect costs must be capitalized to property produced by the taxpayer and property acquired for resale. Section 162 allows a current deduction for amounts paid of incurred for incidental repairs and maintenance and does not require capitalization of these amounts.
The regulations under § 1.263(a)-3(h) permit qualifying small taxpayers to forego application of the improvement rules on eligible building property. This safe harbor for small taxpayers has the following requirements for qualifying:
- Be a qualifying small taxpayer (average annual gross receipts for three preceding tax years less than or equal to $10m)
- Own (or lease) eligible building property;
- Not exceed the applicable cost of improvement threshold; and
- Properly elect the safe harbor.
Under the tax code, Congress established and the IRS oversaw a more rewarding accelerated depreciation system to induce companies to invest and expand their operations, thereby growing the economy. Or so the argument goes.
While there is much debate about the effectiveness of the MACRS system, many corporate managers have not shown bias toward the tax benefit and taken advantage of it nevertheless.
Despite the unclear evidence of whether accelerated depreciation truly increases investment in the long-run, it has provided companies with ample opportunity to use time value of money to their advantage. This is because corporations can use MACRS depreciation, bonus depreciation, and Section 179 deductions to accelerate their depreciation expense from a tax perspective.
Doing so lowers their tax burden today when a dollar is worth more while increasing it in the future when it is worth less. In other words, the total taxes paid are the same but when they are paid differs.
So long as you provide tax incentives for certain actions, businesses will plan to take advantage of any available opportunity to improve the profitability of their operations.
Readers: Now that you know more about MACRS depreciation and the related concepts, what are your thoughts? Do you use the system in your trade or business to lower your taxable income? What do you like or dislike about the system? What can be improved? Also, if you found this post to be of value, I ask that you please consider sharing it on social media because I need your help getting this out to a wider audience.
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A Disclaimer: The information in this post and on this site is intended to be general and is not intended to be construed or used as tax or legal advice. Check with your tax professional before making business decisions which can affect your taxes.
About the Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey to connect with and help others who share the same goal.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see my the disclaimer on my About Young and the Invested page.