Depreciation Basics – What You Need to Know

retired computerAlthough we have looked at the basics of depreciation a number of times, it is never a bad subject to cover, especially during tax season.

For some, tax season is a time of dread. But not for Small business owners as they forward to asset depreciation, which is the decrease in value of an asset that qualifies as an income tax deduction. According to the fine folks at Paychex “Taxpayers can recover some of the costs of certain property over time…In other words, it’s almost like a yearly allowance that represents the reduction in value of the asset. Ensuring you receive the total tax deduction available to you requires a fundamental understanding of how asset depreciation works:”

  • Assets that depreciate can be either tangible or intangible. Tangible assets are physical assets, such as company cars and machinery. Intangible assets can include software and copyrights. In order for an item to be counted for depreciation, the taxpayer must own the item, use it for business, and have continued use over one year.
  • Depreciation can be spread out over a number of years, giving businesses tax relief in more than one accounting period. Once the property class of the item to be depreciated has been identified from the item list in IRS Publication 946, find the asset’s “placed in service” date. This is the date you started using the asset, but also the date from which asset depreciation begins. Then you can determine the time frame (years) to use for the asset’s recovery period (period of time when depreciation can be spread out).
  • Though there are different depreciation systems, the IRS recommends the Modified Accelerated Cost Recovery System (MACRS). With this system in place, you will have to select the most appropriate depreciation method and convention for calculating depreciation on an item. The most common of these is the General Depreciation System (GDS), though you may be required by law to use the Alternative Depreciation System (ADS).
  • Asset depreciation, at its most basic, is a calculation of the asset’s initial cost (or other basis for depreciation) multiplied by the percentage used for business. From this figure, subtract any credit or deductions that apply to the asset, including expensed portions or bonus first-year depreciation.
  • Calculating depreciation may seem like a challenging part of small business taxation, but it is simplified by using the tables and worksheets found on the IRS website. One example is the MACRS worksheet, which can help keep your figures organized. Information is set up in a grid formation, including each year of the recovery or depreciation period, followed by the cost, allowed percentage to claim for business depreciation, and the corresponding dollar figure. The rates listed in the MACRS percentage tables will help you determine the basis for depreciation. Take the time to read the instructions and follow the steps carefully. The end result could help your business get the most benefit from this valuable income tax deduction.

For more information on asset depreciation and how to calculate it, visit IRS Publication 946: How to Depreciate Property.

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Questions? Comments? Let us know in the comments section below.

More information about Bassets eDepreciation software can be found at Bassets.net or depre123.com. At Bassets register for our live webinar, download a free evaluation copy and get a personalized pricing estimate. At depre123 try out our Free Depreciation Calculator and check out our cloud based fixed assets application.

How To Fill Out Form 4562

How to Fill Out Form 4562If you are a business owner and purchased for business or investment purposes any equipment or machinery in 2014, bought a building or other property, or used a vehicle for business, you need to complete Form 4562, Depreciation and Amortization.

The following is an edited version of an article on Investopedia by Barbara E. Weltman that shows how to complete the form under the most common circumstances. (Read Full Article Here)

Part I

This part of the form is used to elect to expense tangible property, off-the-shelf software and certain types of realty (e.g., a greenhouse) placed in service in 2014 (called the Section 179 deduction). The maximum amount of this deduction is $500,000 for machinery and equipment (or $250,000 for qualified leasehold, retail and restaurant improvements).

Regardless of the deduction amount, you must apply the limitation that restricts the Section 179 deduction to the extent of your business profits (called “taxable income” without regard to certain deductions) for the year.

Part II

This part of the form is used for a special depreciation allowance (also called “bonus depreciation”), which is a 50% allowance claimed in the year that eligible property is placed in service. (For 2015, it’s been eliminated unless reinstated by Congress.)

Do not complete this part for:

Property that is not “eligible property.” Only new property, and not pre-owned property, is eligible.
“Listed property,” which is defined later (in Part V).

Part III

This section is for basic depreciation (other than depreciation for listed property, which is entered in Part V) under the Modified Accelerated Cost Recovery System (MACRS) that was created in 1986 and continues to apply today. A single entry on line 17 is used to report deductions for assets placed in service before 2014 (refer to your prior tax returns or any worksheets you may have retained to determine the amount to enter here).

Details about assets placed in service in 2014 are entered on lines 19a through 19i.

Part IV

This part of the form is merely a summary from parts I, II and III, as well as listed property in Part V. Line 22 is the key entry; it is the amount of depreciation that is deductible. The amount on line 22 is reported on the appropriate line of your tax return.

Part V

This section is for claiming write-offs for listed property: cars weighing 6,000 pounds or less, pickup trucks, computers and peripheral equipment, video recording equipment and other property specifically called “listed property.”

Section A is for the depreciation allowance for listed property, including the Section 179 deduction and bonus depreciation.

Section B is used to provide information about vehicles used by sole proprietors, partners or other “more than 5% owners” or people related to these business owners.

Section C is used by an employer to report certain information on employee use of company vehicles.

Part VI

This part is for any amortization you claim. Amortization costs that begin in 2014 are entered on line 42 (along with a description of the costs and other information); amortization for costs that began before 2014 is entered on line 43.

The Bottom Line

If you didn’t acquire any assets in 2014 and are merely depreciating the cost of assets purchased in prior years, you may not need to complete this form. Not sure about this, or whether you’re up to the task of handling this form? Review the IRS instructions to Form 4562 or consult a tax professional.

This article highlights the basic process of filling out Form 4562. For a step by step version Read Full Article Here:

Questions? Comments? Let us know in the comments section below.

More information about Bassets eDepreciation software can be found at Bassets.net or depre123.com. At Bassets register for our live webinar, download a free evaluation copy and get a personalized pricing estimate. At depre123 try out our Free Depreciation Calculator and check out our cloud based fixed assets application.

Violation of the MACRS 40% Rule for Current Year Asset Acquisitions

The 40% Rule states that when 40% or more of the assets acquired in any given tax year are acquired in the 4th quarter of that tax year, all assets acquired in that year will use the Mid Quarter Convention. Personal Property under MACRS will normally use a Half Year Convention. When a piece of property is placed in service, you are required to use a particular convention to determine the depreciation deduction you will get for the first year. Let’s compare half year to mid quarter:

Half Year (HALFYR): Whether an asset is acquired on the first day of a calendar year or acquired on the last day of a fiscal or calendar year, six months of depreciation is allowed during the year of acquisition. This convention assumes that the asset is acquired in the middle of the year so for the 1st year and last year, only ½ of the allowable annual depreciation can be deducted.

Mid Quarter (MIDQ): Whether an asset is acquired on the first day of a quarter or on the last day of a quarter, one half of the quarters normal depreciation is allowed for the quarter of acquisition. So assets acquired in each quarter are allowed a given amount of cost recovery in the first year:

  • 1st quarter = 10.5 months
  •  2nd quarter = 7.5 months
  •  3rd quarter = 4.5 months
  •  4th quarter = 1.5 months

When an asset that was subject to the mid-quarter convention is disposed, then the cost recovery is determined from the middle of the quarter to the end of the year.

In Bassets eDepreciation there is a built-in utility to perform the MACRS 40% test:

Violation of the MACRS rule

As you can see on the above form, the system will test all of the current year acquisitions to ensure compliance. If the test finds a violation of the 40% rule then you can have the system make the switch on first year convention from half year to mid quarter. The 40% rule does not apply to the purchase of residential rental property, nonresidential realty, or assets that are placed in service but then disposed of before the end of the tax year.

Questions? Comments? Let us know in the comments section below.

More information about Bassets eDepreciation software can be found at Bassets.net. While there you can set up a demonstration, download a free evaluation copy and get a personalized pricing estimate.

The Pros and Cons of Accelerated Depreciation

There was a great blog post today by The Committee For A Responsible Federal Budget. As part of a series of posts entitled The Tax Break-Down this particular post drills down into Accelerated Depreciation. As most know, accelerated depreciation is the single largest tax break in the U.S. And it allows businesses to deduct the cost of their assets quicker than their value  really declines. But, as always, there is more…so much more.

To understand accelerated depreciation, one must first understand that U.S. businesses are taxed on profits – that is, their revenues minus their expenses. Yet because many large expenses are used over a number of years to produce income, they must be “depreciated” over the life of the asset. Accelerated Depreciation allows assets to be depreciated faster than their economic life.

To take advantage of accelerated depreciation, most companies rely on something called the modified accelerated cost recovery system (MACRS), which was adopted in 1986. By comparison, the Alternative Depreciation System – which more accurately reflects economic depreciation – uses longer class lives and relies on a straight-line method, where an item must be depreciated equally over its lifetime.

Although there are over 100 categories, the table below lists a few of the asset classes treated differently under accelerated depreciation.

Source: IRS

Source: IRS

With a quicker depreciation schedule, companies can claim higher expenses and thus lower their short-term taxable income. Although over time a company theoretically pays the same amount of tax, an earlier deduction allows companies to take advantage of “the time-value of money” to reap higher interest savings or investment returns.

Not content just to define Accelerated Depreciation, the The CRFB post also looks into the cost of accelerated depreciation, who it affects, the arguments for and against, and options for reform.

How Much Does It Cost?

Accelerated depreciation is the largest corporate tax expenditure. The Office of Management and Budget (OMB) estimates that accelerated depreciation for machinery and equipment cost nearly $70 billion in 2012 and $274 billion over the next five years.

Who Does It Affect?

Accelerated depreciation is used by most businesses, but because it sets out different schedules for different types of assets, the effective tax rates on investment varies widely. Accelerated depreciation provides much more tax benefit to investments in equipment, which benefit from effective tax rates between 4 and 15 percent lower. The effective tax rate on buildings, on the other hand, generally drops by 4 percent or less.

What are the Arguments For and Against Accelerated Depreciation?

Proponents of accelerated depreciation argue that it is an important incentive to spur business investment and keep effective marginal tax rates on capital investment low.

Opponents of accelerated depreciation argue that it is a clear preference — allowing companies to deduct expenses faster than assets actually wear out — and that it not only distorts businesses decisions of when and how much to invest but also what to invest in and also argue the current system is needlessly complex and tremendously outdated.

What are the Options for Reform and What Have Other Plans Done?

Here are some proposed plans that address this issue:

Simpson-Bowles plan

Wyden-Gregg proposal

President Bush’s 2005 Tax Reform Panel

Heritage Foundation

American Enterprise Institute

President’s Framework for Business Tax Reform

Domenici-Rivlin plan

Center for American Progress

To read the rest of this excellent post click here:

Questions? Comments? Let us know in the comments section below.

More information about Bassets eDepreciation software can be found at Bassets.net. While there you can set up a demonstration, download a free evaluation copy and get a personalized pricing estimate.

Basic Methods for Calculating Depreciation

There are two basic methods of depreciation to choose from when depreciating an asset.  These methods include Straight-line, and Declining Balance at either 200% or 150%.   Choosing among these methods depends on how a company wishes to receive depreciation expenses.

The Straight-Line method is generally the most commonly used method due to its simplicity and consistency of allocating depreciation evenly over the useful life of the asset.  To calculate depreciation under this method, the Cost of the Asset is reduced by the salvage or residual value to arrive at the depreciable basis.  The resulting depreciable basis is then divided by the estimated useful life.

The Double Declining Balance (200% Declining Balance) method is also commonly used, as it follows the same principles as the straight-line method, but does so at twice the rate.  Thus, if an asset has an estimated useful life of 4 years, straight-line depreciation would be at an average annual rate of 25%.  However, under this method, a 50% rate would be used.  This would be done each year until depreciation under this method is lesser than it would be under the straight line method.

Use of a 150% Declining Balance method follows the same principle as the 200% Declining Balance method, except uses 1.5 times the straight-line rate.  Thus, an average annual rate of 25% under straight-line would become 37.5% under 150% declining balance.

While the use of salvage or residual value is discussed here, please note that salvage or residual value are only used for Generally Accepted Accounting Principles (GAAP) and are not allowed for federal tax.

Choosing any of these accelerated methods has the benefit of receiving more depreciation benefits during the beginning of the asset’s useful life at the cost of receiving less later on.  However, many feel that this is more appropriate as the asset is most valuable and usable during the early stages of its life.

Here is a numerical example to illustrate the accelerated effect of double declining balance vs straight line depreciation.  For this example, consider an asset that was purchased for $1,000 with a useful life of five years.  Below are the values of depreciation determined for the five years of the asset’s life based on the two different methods:

Depeciation Calculation Using Straight-line vs 200% Declining Balance

What method(s) do you use?  We would be happy to hear what methods your company uses and any reasoning behind it.

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More information about Bassets eDepreciation software can be found at Bassets.net. While there you can set up a demonstration, download a free evaluation copy and get a personalized pricing estimate.