Q: Tax Playa, what are the rules for depreciating business assets?
Adam, Arlington VA
A: Most business property is depreciated (slowly deducted) using the MACRS system. Each type of property has a class life, and there are different methods that can be employed. Additionally, most small businesses can immediately-expense personal (non-real estate) property immediately using "Section 179" expensing rules.
For much more information on this, consult IRS Publication 946, How to Depreciate Property.
Most business expenses (wages, rent, travel, etc.) can be immediately-deducted in the year paid. However, some business purchases have aspects of an investment as well as current consumption. Examples include buildings, computers, and furniture. These assets have a useful life of longer than a year, and often help contribute to future years' income. As a result, the tax code calls for these items to be slowly deducted over time, or depreciated.
Most depreciation happens under the so-called "MACRS" system. Under this system, the first task is to see what "life" each asset has. While there are more lives that what is listed below, this is all most people ever run into:
- Non-residential rental property: 39 years
- Residential rental property: 27.5 years
- Furniture: 7 years
- Technical equipment: 5 years
The next task to give a "convention" to each depreciation. For real property, the only option is the "mid-month" convention. That is, the asset is placed into service in the middle of the month it was actually bought. As a result, the first month's depreciation is only half-strength, as is the last month's.
For furniture and computer-type equipment, the convention is usually the "half-year" convention. This means that the asset is deemed to be placed in service halfway through the year in which it was purchased. As a result, there is an extra year needed in the depreciation schedule to pick up the final 6 months.
Finally, the taxpayer has to choose the speed at which he wants to depreciate the asset. For real property, the only option is "straight-line" (equal deduction every year). For tangible personal property (furniture and computers), the taxpayer has a choice of straight-line, 150% speed, or 200% speed. The latter two result in higher depreciation deductions for the early years, and lower deductions for the later years.
Thus, someone buying a computer for $1000 and opting for 200% dB HY depreciation would take the following depreciation deductions:
Year 1: $200
Year 2: $320
Year 3: $192
Year 4: $115
Year 5: $69
Year 6: $104
At the end of the sixth year, the asset is fully-depreciated.
Another option that small businesses have is to immediately expense the cost of furniture and computer depreciation in the first year. This is called "Section 179 expensing" after the tax code section. Up to $128,000 of such tangible personal property can be expensed in 2008, but this phases out dollar-for-dollar once $628,000 or more of such property is placed in service in a given year (these numbers are indexed to inflation).
It's important to note that depreciation deductions taken reduce the taxpayer's cost basis in an asset. For instance, suppose the above computer-depreciating taxpayer decides to sell after year 2. His cost basis went from $1000 to $480 because of the $520 in depreciation he claimed.
Suppose he sells the computer for $500. He has a gain of $20 ($500-$480 basis). This gain is treated as a short-term capital gain, and he pays ordinary income tax on it.
An important exception to this rule is "depreciation recapture" from the sale of real property. Gains on this income are taxed at a maximum rate of only 25%, even though the depreciation deductions count against ordinary income.
Needless to say, don't try to do this without a competent tax professional.