U S Taxation– Depreciation– Interesting facts to gather, learn & apply

It was an arranged meeting of friends, all, accounting professionals with more than 30 years of experience when I met two of my friends on a sunny day, recently. We discussed serious accounting issues also, among other things and got into “depreciation standards” in India and abroad for expensing in the tax year. When I explained, the standards adopted in USA which stand out drastically from the ones used in India, my friends wanted me to write about claiming depreciation in USA. The following article is based on the instructions from Internal Revenue Service, U.S.A., (IRS), one of the best tax authorities in the world. Who does not want to hear about American experience in accounting which has produced world leaders in business?

Depreciation

Depreciation is an income tax deduction that permits a taxpayer to recover the cost or other basis of certain property. Obviously, it an annual allowance for the wear and tear, deterioration, or obsolescence of the property.

Tangible properties like buildings, machinery, vehicles, furniture, or equipment are depreciable. To the next question whether intangible property like patents, copyrights or computer software is depreciable, the answer is “yes”.

Following the sequence, the property which meets the following requirements is allowed depreciation:

• The taxpayer owns the property and he/she can also depreciate any capital improvements for the property.
• It is simply natural that the property is used in business or in an income-producing activity. Yes, someone may use it partially for business or otherwise for personal purposes. In that case, the usage for business needs to be calculated for depreciation purposes.
• The property needs to have a determinable life of more than one year.

Naturally the following property even if meets the above requirements, can’t be depreciated:

• Property placed in service in the same year and also disposed of within the same year.
• Equipment used to build capital requirements. The taxpayer needs to add otherwise allowable depreciation on the equipment during the period of construction to the basis of the improvements.
• Certain term interests.

A taxpayer has to identify the following items to calculate proper depreciation of a property to ensure its correctness:

• The class life of the property
• The depreciation method for the property
• Ensuring the property is a “listed property’, and the taxpayer elects to expense some portion of the property.
• Whether the taxpayer qualifies for any “bonus” first year depreciation
• Obviously, the depreciable basis of the property.

For an enlightened professional, it is clear that depreciation begins only when the property has been put in service for business or for an income generation activity. Whenever the full cost or basis of the property has been recovered, the property ceases to be depreciable. But if it has been taken out of service earlier, it is not equally ineligible for depreciation.

The Modified Accelerated Cost Recovery System (MACRS) is the depreciation method for most property. However, several methods of claiming deductions for the purchases made during 2016 of equipment, fixtures, autos, and trucks used in business may be mentioned or explained as under:

• First year expensing, popularly known as Section 179 deduction which amounts to $5,00,000. Properties ineligible under this category include properties leased out to others, properties used by governmental units, property used predominantly to furnish lodging or air conditioning or heating units placed in service during the tax years beginning 2016.
• Regular depreciation, which allows a prorated depreciation over a period of years during the service of the property. Most of the property under MACRS is depreciable over a period of 6 years. This applies to both new and old property. MACRS provides rapid depreciation and eliminates unambiguity over useful life, salvage value, and depreciation methods.
• Certain investments in buildings are depreciable using straight-line method; residential buildings over 27.5 years while non-residential real property in service after May 12, 1993 over 39 years. Specific annual rates for each class of property are provided by IRS tables. Relevant references are given at the end of this article and as recommended earlier, a good CPA would take care of this actual assignment.

Basis for depreciation

Any accounting student will agree that the basis of the property on which one would figure out the depreciation is its adjusted basis which during the first year is its cost. If one converts the property from personal usage to business usage, the basis for depreciation is its adjusted basis or the its fair market value whichever is less. If one has a full limit of $5,00,000 but the qualifying property has the basis of only $1,00,000, then one can’t claim the full limit which is an obvious fact. However, in case, the property eligible for depreciation exceeds the available limit, the case may be explained as under:

One has put in service two properties of basis $2,50,000 and   $2,60,000, then total of $5,00,000 is deducted leaving the second property with the basis of 10,000 to be carried forward for the next year.

Similarly, the total depreciation can’t exceed net income from all active businesses. Though most of the matter is plain accounting matter, explanations make it easier to understand and apply wherever required.

In case, the total cost of qualifying property in service in 2016 exceeds $2 million, the    $5,00,000 expensing limit is reduced dollar by dollar by the cost of qualifying property exceeding $2 Million.

Limit is reduced if spouses file tax returns under” married filing separately” category which means $2,50,000 separately.

MARS consists of two depreciation systems, General Depreciation System(GDS) and Alternative Depreciation System(ADS). A tax payer is expected to use GDS unless specifically told to use ADS or an election is made to use ADS.

Regular MARS (GDS)

The GDS, referred to as “regular MARS” uses shorter recovery periods and accelerated higher depreciation percentages than the ADS.

MARS provides three depreciation methods under GDS:

• 200% declining balance(200DB). 200DB is the regular depreciation method for 3-, 5-, 7-, and 10-year non-farm property. It provides for a greater deduction in the early recovery years and then switches to straight-line(SL) method when it yields a larger depreciation allowance.
• 150% declining balance (150 DB). 150 DB is the regular depreciation method for farm property (except real property), and 15- and 20- property (except qualified leasehold improvement, qualified retail improvement, and qualified restaurant property placed in service before Jan 1, 2015).  It provides for a greater deduction in the early recovery years and then switches to straight-line(SL) method when it yields a larger depreciation allowance.
• Straight Line(SL). SL is the regular MARS recovery method for residential and non-residential real property.

Conventions

Conventions establish the point in the tax year when MACRS property was considered to have been placed in service or disposed of for the purpose of computing depreciation. It is presumed to have been placed or disposed of on the midpoint of the month, quarter, or year regardless, obviously, of the actual date on which it was actually placed in service.

Some of the details of above facts may explain the situation more explicitly.

Convention, mid-month:

Multiply full year depreciation amount with the fraction with numerator equal to the number of months the property was in service (also to include a half-month) and the denominator equal to 12.

Convention, Mid-Quarter:

To multiply full-year depreciation by the following percentages depending upon the quarter placed in service.

1^st quarter ———————87.5% (=3.5/4)

2^nd quarter———————62.5%(=2.5/4)

3^rd quarter———————-37.5%(=1.5/4)

4^th quarter———————–12.5%(=0.5/4)

Half-year depreciation

Multiply full-year depreciation by 50%

Is it so?

It is interesting to know that mid-quarter and half-year conventions are determined to a fiscal year, as well as a calendar year.

For example:

• If the tax year begins on May1 and ends on April 30, the mid-quarter dates are June15, September 15, December 15 and March15. The mid-year date is (October 31)

Short Tax Year

To a question as to how does one understand a short tax year, the answer is simply put as any tax year with less than 12 months. A short tax year happens in the first or last year of corporation, a partnership or an estate’s existence. The rule is that one can’t apply MACRS tables for a short tax year. But, however, one can apply Section 179 depreciation which is not limited by short year depreciation rules. Hence, it is easier to apply the same on a short tax year.

Section 179 Expense

Now let us delve with one of the most commonly used depreciation, popularly known as “Section 179 Expense”. To qualify as Section 179 expense, the same must be used over 50% in business or trade and a portion of the deduction must be recovered if business use falls below 50% in any year during the recovery period.

The property can be new or used and must have been acquired by purchase meaning gifted, inherited, or traded one does not qualify.

Common property for Section 179 deduction may be one of the following:

• Automobiles
• Equipment
• Furniture
• Livestock not treated as inventory
• Machinery
• Office equipment
• Oil and gas well- equipment
• Single purpose agricultural
• Storage facilities (except buildings and their structural components)
• Trucks

Non-qualifying property

• Air-conditioning units
• Barns
• Bridges
• Buildings
• Elevators
• Heating units

Section 179 deduction dollar limits.

The maximum amount you can elect to deduct for most section 179 property you placed in service in tax years beginning in 2015 is $500,000 ($535,000 for qualified enterprise zone property). This limit is reduced by the amount by which the cost of section 179 property placed in service during the tax year exceeds $2,000,000 ($2 million). One may have to refer to Publication 946 published by IRS for the latest information for the tax year 2016 for deciding Section 179 expense.

Limitations to apply Section 179 expense

Individuals

Total of the following:

• Net profit from sole proprietorship before 179 deduction and self-employment tax deduction
• Employment wages, even if unrelated to Section 179 property
• Ordinary pass-through income from partnerships or S corporations
• Ordinary income from depreciation recapture under section 1245 and section 1250, and gain/loss from sale of business assets under section 1231

Partnership or S corporation

• Section 179 deduction, tax-exempt income, guaranteed payments and credits
• Shareholder-employee compensation
• Partner’s allocable share of taxable income

        C-corporation

• Total net taxable income from all trades or businesses actively conducted by the entity, without considering the section 179 deduction, net operating losses and special deductions; income or deductions derived from a trade or business not actively conducted during the tax year.

                Intangible Property

Generally, if one can depreciate intangible property, he/she usually uses the straight- line method of depreciation. However, one can choose to depreciate certain intangible property under the income forecast method also.

Income forecast method

One can choose to use the income forecast method instead of the straight- line method to depreciate the following depreciable intangibles:

• Motion picture films or video tapes.
• Sound recordings. Copyrights.
• Patents.
  

 Under the income forecast method, each year’s depreciation deduction is equal to the cost of the property, multiplied by a fraction. The numerator of the fraction is the current year’s net income from the property, and the denominator is the total income anticipated from the property through the end of the 10th taxable year following the taxable year the property is placed in service.

 For more information, see section 167(g) of the Internal Revenue Code. Films, video tapes, and recordings. One cannot use MACRS for motion picture films, video tapes, and sound recordings. For this purpose, sound recordings are discs, tapes, or other phonorecording resulting from the fixation of a series of sounds. One can depreciate this property using either the straight-line method or the income forecast method.

 Participations and residuals.

 One can include participations and residuals in the adjusted basis of the property for purposes of computing the depreciation deduction under the income forecast method. The participations and residuals must relate to income to be derived from the property before the end of the 10th taxable year after the property is placed in service.

 For this purpose, participations and residuals are defined as costs which by contract vary with the amount of income earned in connection with the property. Instead of including these amounts in the adjusted basis of the property, you can deduct the costs in the taxable year that they are paid.

Videocassettes

 If one is in the business of renting videocassettes, he/she can depreciate only those videocassettes bought for rental. If the videocassette has a useful life of one year or less, he/she can currently deduct the cost as a business expense.

Alternative Depreciation System (ADS)

Under ADS, depreciation is undertaken using SL method. ADS recovery methods are longer for most of the assets, resulting in a less accelerated method of cost recovery than under GDS.

Why to use ADS? Is it mandatory?

Under American taxation systems, everything evolved over a period of time and the business men liked clear rules and regulations that would help him to dream big and build systematically so that the empires built by them survived their deaths and professional managers took over their running. The word management evolved due to this arrangement.

ADS is mandatory for the following property:

• Listed property used 50% or less for business – auto used for business is a listed property which requires business use for more than 50% of business.
• Tangible property used predominantly outside the United States.
• Property used for tax exempt purposes
• Property financed by tax exempt bonds
• Certain property imported from trade restrictions by Presidential Executive Order. To know what is a Presidential Executive Order, any recent newspaper headline would explain. Interestingly, ISRO was under trade restrictions after India joined countries which possessed nuclear capabilities

Alternative Minimum Tax adjustment is not required for property covered under ADS depreciation.

Intangible assets and depreciation

I am not amused when a serious accounting student raises the ambit of Intangible assets and whether they can be depreciated. Yes, one can depreciate them under US Taxation and the following may quench their inquisitive minds.

Section 197 Intangibles

 The acquisition costs of purchasing goodwill and certain other section 197 intangibles assets are amortized over a 15-year period (180 months). Amortization begins the later of (1) the month the intangible is acquired, or (2) the month the trade or business or activity engaged in for the production of income starts. Some of the amortizable Section 197 intangibles which were acquired and eligible for depreciation are given as under:

1. Goodwill
2. Workforce in place
3. Business books and records, operating systems or other information base
4. Patent, copyright, formula, process, design, pattern
5. Customer based intangibles such as customer base, circulation base, or other mortgage servicing contract
6. Licenses, permits, or other rights given by governmental unit or agency
7. Franchise, trademark or trade names

Example

Let us enumerate one example for easy understanding. Ms. Priyanka sold her business along with its goodwill to another business firm for $1,00,000. The goodwill fetched her $20,000 which was self-created. Yes, at her hands, it is not a Section 197 intangible. However, the other business which bought the goodwill can use it as a Section 197 intangible and use the available depreciation method to amortize over a 15-year period (180) months.

Other frequently asked questions not dealt with the writer under depreciation:

• Section 179 recapture
• Special depreciation allowance
• Leasehold and Retail Improvements and Restaurant Property
• Central Asset Accounts (GAA)
• Depreciation Adjustments for Alternative Minimum Tax
• Correcting depreciation errors
• Miscellaneous depreciation issues
• Depletion
• Depreciation for Like-Kind-Exchanges and Involuntary Conversions
• MACRS Recovery Periods for 5-year property/7-year property/10-year property/15-year property/20-year property/27.5- year property/39- year property

Conclusion

The author has raised certain fundamental questions, under US Taxation, related to depreciation of properties under various methods, conventions used, Section 179 deduction, Section 197 deductibles, and given various examples to explain the concepts. The writer is of the firm opinion that as a nation, India with nearly 65% of its population, mostly literate or tend to be literate has evolved as a globalized nation and has converged its accounting, IND As, as IFRS converged. Even the conservative sector like banking has been emerging as a beacon for the Indian economy. This article naturally tries to answer some questions related to US Taxation- Depreciation. With the emergence of India as a Developed nation, it will not be far off when Indian accounting would completely absorb the concepts that may favor our businesses who would, in turn, demand the same for earning more money.

It is expected that the services of an experienced CPA from USA would help the industries who actually need the application of above concepts while filing their tax forms for any tax year. 

References

1. IRS Pub. 946, How to depreciate property
2. Form 4562, Depreciation and Amortization
3. Deluxe edition of Tax Book for the year 2015, for Federal 1040 -small business, Estates, Trusts( millions of this book is read/followed by CPAs from USA. It is an amazing book).
4. IRS Pub.534 Depreciating Property Placed in Service before 1987  
   

About the author

About the author: Subramanian Natarajan C.P.A. (USA), M.Sc., CAIIB took voluntary retirement in 2000 from Punjab National Bank after handling various facets of banking like deposit mobilization, foreign exchange, auditing and borrower accounts. After living in USA for 12 years during which period he worked in various international auditing firms specializing in international tax, auditing, IND AS-IFRS(Banking) etc., he continues his practice in New Delhi, India. He can be reached at subcpa@gmail.com. Tel: 7503562701, 9015613229. He currently lives in Delhi. His name appears as tax consultant in web site of American Embassy, New Delhi. He is thankful to various suggestions received from readers and is delighted to see enormous enthusiasm of readers.