An asset's basis is the maximum amount of investment in an asset that can be subtracted from income as a capital recovery. The depreciation rules in effect when an asset is placed in service determine the depreciation method to be used during the life of the asset. An asset is placed in service when it is set up and ready for its intended use for a business purpose.
For assets placed in service prior to 1987 the depreciation method that should be used is the Accelerated Cost Recovery System (ACRS). Assets placed in service after 1986 are depreciated under the Modified Accelerated Cost Recovery System (MACRS). You cannot change to MACRS for property placed in service prior to 1987 that is being depreciated under another method such as ACRS
The primary difference between the two systems is that MACRS specifies longer recovery periods for depreciable assets, which results in slower depreciation than allowed by ACRS. There is a direct correlation between the useful life of an asset and the size of the depreciation deduction in a given year. The longer the useful life the smaller the deduction becomes. And as a general rule, the earlier you can claim a depreciation deduction, the greater its present value.
For more information on depreciation and depreciation methods please refer to IRS Publication 946.
Modified Accelerated Cost Recovery System (MACRS)
To simplify the depreciation calculation the IRS has developed tables which incorporate the recovery period, depreciation method and the specific conventions to be used in the acquisition and disposition year. Under MACRS an asset's depreciable basis is multiplied by a percentage obtained from one of the IRS tables to determine the depreciation deduction. The tables can be found in IRS Publication 946, How to Depreciate Property.
Note: The IRS Tables are in PDF format, if you do not have Adobe Acrobat Reader you may need to install it
MACRS applies to new and used tangible depreciable property. Tangible depreciable property includes buildings, land improvements and equipment. Tangible property can be depreciated only if it is used in a trade or business or held for the production of income and has a determinable life. Land, intangible assets, and personal use assets cannot be depreciated under MACRS.
You can depreciate the business basis of a mixed-use asset but not the personal use part. However, when determining the business portion of a mixed use asset you need to consider the listed property rules. A typical business asset that is not subject to depreciation is inventory. When inventory is sold, its cost basis is subtracted from sales as a deduction for the cost of goods sold.
Depreciable basis is the assets original basis for depreciation, less any amount deducted under the Section 179 election to expenses assets. An assets basis for depreciation does not have to be reduced by its salvage value. The depreciable basis does not change during an asset's tax life unless additional capital expenditures are made for the asset. The total capital recovered as a depreciation deduction over an asset's useful life can never be more than its depreciable basis.
Note: An assets depreciable basis is not the same as the adjusted basis. Adjusted basis refers to the unrecovered capital of an asset at any point in time. An asset's adjusted basis decreases as depreciation deductions are taken.
Under MACRS, property is assigned a class life that determines the depreciation recovery period. MACRS provides 3, 5, 7, 10, 15 and 20 year recovery periods for property other than real estate. Most personal property is in the 3, 5 or 7 year class. The 10, 15 and 20 year classes generally include land improvements and specialized types of buildings and other property. Residential rental real estate has a 27.5 year recovery period, whereas nonresidential real estate placed in service before May 13, 1993 has a 31.5 year recovery period. The recovery period for nonresidential real estate placed in service after May 12, 1993 is 39 years. If personal property is not listed in a specific asset class or identified with a specific industry it is assigned a 7 year recovery period.
Section 186 of the Internal Revenue Code prescribes the applicable conventions to be used under MACRS: mid-year, mid-month and mid-quarter conventions. All IRS percentage tables specify the convention being used by that particular class life. The exact date of acquisition or disposition is not crucial in making the appropriate allocation.
Note: If you want to maximize depreciation deductions plan your personal property purchases to avoid making more than 40 percent of such purchases during the last three months of the tax year. In certain situations the Section 179 election can be used to avoid the mid-quarter convention by expensing assets purchased in the fourth quarter.
Under current tax laws you have three alternatives for calculating depreciation:
The decision on which alternative to use will depend on whether you want to maximize or minimize the deduction in the year of acquisition. To maximize the deduction in the year of acquisition use the Section 179 election and regular MACRS for the remaining depreciable basis.
Note: Electing to use ADS may be appropriate in years in which you have low income or losses and the higher MACRS deduction is not needed. Another reason to use ADS is to avoid the alternative minimum tax. If you have large purchases of depreciable assets you may be subject to the alternative minimum tax because of the greater MACRS depreciation deductions.