Don’t Overlook The Value Of Depreciation Deductions
Posted on Monday, June 04, 2012
As businesses weather challenging economic times, one boost can come from depreciation. The term "depreciation" is often associated with complicated accounting and tax transactions but the fundamental concept is fairly simple. Depreciation should not be overlooked as a valuable tool.
Depreciation is essentially an income tax deduction. Depreciation allows you to recover the cost or other basis of qualified property. The rules for depreciation vary depending on the type of property. In recent years, these rules have been made more complex by tax legislation for bonus depreciation and special treatment of certain property. We'll discuss bonus depreciation later.
Generally, tangible property is depreciable. Tangible property is depreciable if it is subject to wear and tear. Tangible property includes machinery and equipment, motor vehicles, and furniture. Land, however, is not tangible property for depreciation purposes. Intangible property also may qualify for depreciation. One of the most widely used types of intangible property in every business activity is computer software. Copyrights and patents, which are intangible property, are also depreciable. Many types of property are not depreciable (although there are always exceptions). One type of business property that is not depreciable is inventory.
To be depreciable, the property, whether tangible or intangible, must be used for business or in other income-producing activities. It is not the nature of the property itself which is determinative but rather the purpose for which the property is held. If you use property for business and for personal purposes, you can only deduct depreciation based only on the business use of that property.
Depreciation begins when a taxpayer places property in service for use in a trade or business or for the production of income. The property must have a determinable useful life of more than one year. Property that is placed in service and disposed of in the same year cannot be depreciated. Property ceases to be depreciable when you have fully recovered the property's cost or other basis or when you retire it from service, whichever happens first.
Let's look at an example: Olivia owns a small candy company. Olivia purchases a new candy-making machine. The machine is delivered in November 2012. However, the machine is not installed and operational until February 2013. If the machine had been ready and available for use when it was delivered, it would be considered placed in service in 2012 even if it was not actually used until 2013.
Generally, the method for calculating depreciation is determined by the type of property and when the property was placed in service. For tangible property, there are currently three systems of depreciation in effect, depending on when the property was placed in service. They are the modified accelerated cost recovery system (MACRS) for property placed in service after 1986, the accelerated cost recovery system (ACRS) for property placed in service after 1980 but before 1987, and the pre-1981 system (which included the straight-line method, declining-balance method, and certain other methods based on useful life and salvage value) for property placed in service before 1981.
Bonus depreciation is intended to encourage businesses to make capital investments by enabling them to write these investments off more quickly. Under current law, 50 percent bonus depreciation is available for qualified property acquired after December 31, 2007 and placed in service before January 1, 2013 (before January 1, 2014 in the case of certain property with a long production period and certain noncommercial aircraft). A 100 percent bonus depreciation rate applies to property acquired after September 8, 2010 and placed in service before January 1, 2012 (before January 1, 2013 for certain property with a long production period and certain noncommercial aircraft). Several bills are pending in Congress to extend 100 percent depreciation through 2012.
Let's look at an example: ABC Co., a calendar-year taxpayer, acquires and places in service business equipment that costs $1 million on June 1, 2012. Under current law, ABC may claim an additional first-year depreciation deduction of 50 percent of the basis of the property, or $500,000. The remaining $500,000 of adjusted basis is recovered under the depreciation provisions other than the additional allowance.
While the basic concept of depreciation itself may be simple, strategies in its implementation to minimize tax liability sometimes may not be so straightforward. Decisions over whether to classify a particular asset within one or another depreciation "class," whether certain components of a building can be depreciated faster than the building itself, whether something is an improvement that requires depreciation or a repair that may be deducted immediately in full, and whether early disposition of a particular asset raised the pitfall of depreciation recapture are some of the many "fine points" surrounding depreciation that can make a significant difference in a business' taxable income.
If you have any questions about depreciation, please contact our office.
Posted in Tax And Accounting Topics For Business
Disclaimer: The information contained in Dulin, Ward & DeWald’s blog is provided for general educational purposes only and should not be construed as financial or legal advice on any subject matter. Before taking any action based on this information, we strongly encourage you to consult competent legal, accounting or other professional advice about your specific situation. Questions on blog posts may be submitted to your DWD representative.