For business and investment purposes, the purchase price of property (or major improvements to property) that are expected to last for more than one year, cannot be claimed fully as a deduction in the year of purchase. Rather, the purchase price is divided over a number of years. The yearly deductible expense is called “depreciation.”
Depreciation can get a little nuanced, but this post will focus on the fundamentals. We may explore some of the more complicated aspects in future posts.
Straight-line depreciation
As just mentioned, depreciation can get a little complicated and many assets are not depreciated using the straight-line method. However, understanding straight-line depreciation is the best place to start.
As said above, expensive assets with long lives cannot be expensed in a single year, as other business expenses are. Rather, the cost needs to be spread over multiple years. The number of years a property is depreciated depends on the type of property. For example:
Cars/trucks are depreciated over 5 years.
Office furniture is depreciated over 7 years.
Residential rental property is depreciated over 27.5 years.
Non-residential real estate is depreciated over 39 years.
Under straight-line depreciation, the property’s cost basis (see previous post) is divided by the depreciation period. In reality, there can sometimes be adjustments made for the salvage value of the asset (residual value after the asset is fully depreciated) and the time of year the asset is placed into service.
But for illustrative purposes, the depreciation on a $50,000 truck would be $10,000/year. This is calculated by dividing the cost basis of $50,000 by the depreciation period of 5 years (50,000 / 5 = 10,000).
The depreciation on a residential rental property with improvements not including land (as land is not depreciated) of $400,000 would be $14,545/year. This is calculated by dividing the cost basis of $400,000 by the depreciation period of 27.5 years (400,000 / 27.5 = 14,545).
MACRS
In reality, the Modified Accelerated Cost Recovery System (MACRS) is the system used to depreciate most types of property for tax purposes. It is more complicated than just using straight-line depreciation, as described above. For many assets, accelerated depreciation (in excess of what’s available under the straight-line method) is available in the earlier years of the property’s life. This allows businesses and investors to get a more immediate tax deduction.
Special Depreciation & Section 179
In addition to the acceleration under MACRS, there are additional provisions, “Special Depreciation” and “Section 179” that allow taxpayers to further accelerate the depreciation on property. This can result in a vast majority or all of the cost basis being recovered in the first year that property is placed into service. We will not discuss the specifics of special or section 179 depreciation here.
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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