Depreciation allows businesses to allocate the cost of assets—such as buildings, equipment and machinery, vehicles, and furniture—over the years the assets will be used. For internal accounting purposes, most businesses depreciate assets using the straight-line method.
But when it comes to claiming depreciation on the company's tax return, the IRS requires most businesses to use the modified accelerated cost recovery system, also known as MACRS.
MACRS depreciation was introduced in 1986 to encourage businesses to invest in depreciable assets by allowing larger depreciation deductions in the initial years of the asset's useful life. This contrasts with straight-line depreciation, where the business gets the same deduction each year until the asset is fully depreciated.
How to calculate MACRS depreciation
Taxpayers can use MACRS depreciation for vehicles, office furniture, machinery, land improvement, computer equipment, and many other assets.
To calculate MACRS depreciation:
1. Determine the basis
Typically, the depreciation basis of an asset is what you paid for it. However, it can include other expenses of acquiring the asset and getting it ready to use.
For example, if you buy a piece of manufacturing equipment for $20,000 and spend another $2,000 to have it delivered and installed, the depreciable basis would be $22,000.
2. Determine the property's class
MACRS organizes assets into different classes based on their useful life. IRS Publication 946 includes several examples of the type of property included in each class. Here are a few common examples:
- 3-year property: tractors and most horses
- 5-year property: vehicles, computer equipment, office machinery, cattle, and appliances used in a residential rental property
- 7-year property: office furniture and fixtures
- 10-year property: water transportation equipment and some agricultural buildings
- 15-year property: land improvements (such as fences and sidewalks) and qualified tenant improvements
- 20-year property: farm buildings and municipal sewers
- 27.5-year property: residential rental properties
- 31.5-year property: non-residential real property
Three-year, 5-year, 7-year and 10-year property uses the 200% declining balance method. This means you take 200% of the amount that would be depreciated using the straight-line method. Fifteen-year property uses the 150% declining balance method, meaning you claim 150% of the amount that would be depreciated using the straight-line method.
3. Determine the placed-in-service date
In some cases, the placed-in-service date is the date the property was purchased, but those dates can be different. An asset is considered "in service" when it's ready and available to be used.
For example, say you purchase a piece of equipment in December, but it's not delivered and installed until January of the following year. Even though you paid for the equipment in December, you can't start deducting MACRS depreciation until January.
4. Determine which convention applies
The convention you use determines the number of months you can claim depreciation in the asset's first year.
There are three conventions:
- Mid-month convention. Under MACRs, buildings are depreciated using the mid-month convention, which starts depreciating all property placed in service during the month at the midpoint of the month. For example, if you purchase a residential rental property on January 30, you can claim half a month's worth of depreciation in January.
- Mid-quarter convention. The mid-quarter convention is used for any property placed in service during the last three months of the tax year unless the asset must use the mid-month convention. For example, you can claim 1½ months of depreciation for any equipment placed in service in December (assuming your company's year-end is Dec. 31).
- Half-year convention. The half-year convention applies to any property that doesn't require using the mid-month or mid-quarter convention. Under this convention, you can begin depreciating all property placed in service during the tax year as of the year's midpoint. So if you purchase a piece of equipment in January, you can claim a half year of depreciation that year.
5. Calculate MACRS depreciation
Now that you have all the necessary information, you can calculate the percentage of the asset's basis that you can deduct in the first year using the following MACRS formula:
First year depreciation = Basis x (1 / useful life) x Depreciation method x Depreciation convention
In the following years, the formula to use would be:
Subsequent years depreciation = (Basis – Depreciation in previous years) x (1/ useful life) x Depreciation method
To see how that works in practice, say you purchase a computer for $1,000, and the half-year convention applies. Computer equipment is 5-year property, so you need to use the 200% declining balance method.
Using this information, the first year's depreciation expense would be:
$1,000 x (1/5) x 200% x .5 = $200
The following year, depreciation expense for the computer would be:
($1,000 - $200) x (1/5) x 200% = $320
If you prefer, you can use the MACRS depreciation tables in Publication 946 to calculate depreciation or use a MACRS depreciation calculator.
Calculating MACRS depreciation can be complicated. If you don't want to handle it on your own, you might want to leave it to your accountant so you can focus on other aspects of running your small business.