Depreciation Methods
The depreciation method that you use for any particular asset is fixed at the time you first place that asset into service. Whatever rules or tables are in effect for that year must be followed as long as you own the property. Since Congress has changed the depreciation rules many times over the years, you may have to use a number of different depreciation methods if you've owned business property for a long time.
For most business property placed in service after 1986, if you don't claim the equipment expensing deduction for the full cost of the item, the IRS requires you to depreciate the asset using a method called "MACRS," which stands for Modified Accelerated Cost Recovery System This method categorizes all business assets into classes and specifies the time period over which you can write off assets in each class. The most commonly used items are classified as shown in the chart that follows.
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Class of Property
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Items Included
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3-year property
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Tractor units, racehorses over two years old, and horses over 12 years old when placed in service |
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5-year property
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Automobiles, taxis, buses, trucks, computers and peripheral equipment, office machinery (faxes, copiers, calculators etc.), and any property used in research and experimentation. Also includes breeding and dairy cattle. |
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7-year property
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Office furniture and fixtures, and any property that has not been designated as belonging to another class. |
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10-year property
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Vessels, barges, tugs, similar water transportation equipment, single-purpose agricultural or horticultural structures, and trees or vines bearing fruit or nuts. |
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15-year property
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Depreciable improvements to land such as shrubbery, fences, roads, and bridges. |
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20-year property
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Farm buildings that are not agricultural or horticultural structures. |
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27.5-year property
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Residential rental property. |
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39-year property
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Nonresidential real estate, including home offices. (Note that the value of land may not be depreciated.) |
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Save Money
Under special tax law provisions intended to help stimulate the economy, businesses are now entitled to take an additional first-year depreciation deduction equal to 30 percent of the value of certain types of qualified property before calculating their normal depreciation deductions. The extra depreciation bonus can also be taken before and together with the first-year expensing deduction.
Qualifying property includes:
- property with a recovery period of 20 years or less (which, as the table above shows, really covers a lot of property);
- water utility property (generally a benefit to businesses using equipment for the gathering, treatment, or commercial distribution of water);
- most types of computer software (except software that is considered an intangible asset that has to be amortized, rather than depreciated); and
- qualified leasehold improvements to nonresidential real property (except enlargement of the building, installing an elevator or escalator, improvements to common areas, or improvements to the building's structural framework).
The depreciation bonus applies to property acquired after September 10, 2001, and before September 11, 2004. Also, the property must be placed in service on or after September 11, 2001, and before January 1, 2005.
Businesses located in the New York City Liberty Zone (essentially southern Manhattan) also get to apply the depreciation bonus to real property (e.g., buildings) rehabilitated or replaced after the September 11 terrorist attacks, and to used property. In addition, Liberty Zone businesses generally have until the end of 2006 to place qualifying property in service (2009 for nonresidential real property and residential rental property).
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Some assets are not eligible for MACRS depreciation, including intangible assets such as patents, trademarks, and business goodwill. Generally these must be amortized (written off in equal amounts) over a 15-year period, beginning in the month of acquisition. Off-the-shelf computer software must be amortized over 36 months.
Once you know the classification and the tax basis of the asset you need to depreciate, you can use a special table provided by the IRS to determine the percentage of the item's tax basis that can be deducted each year. MACRS provides for a slightly larger write-off in the earlier years of the cost recovery period. The full set of depreciation tables showing the MACRS percentages are available in the IRS's free publication 946, How to Depreciate Property, available on the Internet at http://www.irs.gov or by calling 1-800-TAX-FORM.
As an example, the following chart shows the depreciation amounts under MACRS for office furniture purchased in 2001 for $10,000. The amounts in the third column are taken from the MACRS half-year convention table, which is the one most commonly used. Notice that the asset's tax basis does not change over the years -- only the percentage used as a multiplier changes each year.
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Year
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Basis
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Percentage
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Deduction
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| 2002 |
$10,000 |
14.29% |
$1,429 |
| 2003 |
$10,000 |
24.49% |
$2,449 |
| 2004 |
$10,000 |
17.49% |
$1,749 |
| 2005 |
$10,000 |
12.49% |
$1,249 |
| 2006 |
$10,000 |
8.93% |
$893 |
| 2007 |
$10,000 |
8.92% |
$892 |
| 2008 |
$10,000 |
8.93% |
$893 |
| 2009 |
$10,000 |
4.46% |
$446 |
If you do not use the asset 100 percent for business, then each year you must multiply the asset's total tax basis by the business percentage for that year, and then multiply the result by the fraction found in the table.
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Example
If, in 2003, you use the office furniture from the previous example only 50 percent for your business, you would multiply the $10,000 tax basis by .50, and then multiply the result by .2449 to get your final depreciation figure.
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Some special variations of MACRS, or other depreciation methods, are available (or even mandatory) in certain situations.
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