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 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:
Naturally the following property even if meets the above requirements, can’t be depreciated:
A taxpayer has to identify the following items to calculate proper depreciation of a property to ensure its correctness:
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:
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:
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.
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.
To multiply full-year depreciation by the following percentages depending upon the quarter placed in service.
1st quarter ———————87.5% (=3.5/4)
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.
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:
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
Total of the following:
Partnership or S corporation
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:
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.
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:
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:
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:
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.
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 firstname.lastname@example.org. 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.