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Depreciation

Depreciation

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Last Reviewed: Feb 2011

Last Modified: Feb 2011

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Depreciation is a concept that takes a little getting used to. The basic idea is to spread the cost of equipment or other assets over their useful lives in order to match that cost against the income it is helping to produce. A $7,000 breeding dog with an expected useful life of seven years would be deducted $1,000 per year. This simple concept, however, has been fiddled with innumerable times over the years, to the point it is now one of the most complex areas of the tax code. But all the tinkering can be boiled down to the question of how quickly assets can be depreciated, so let's review the current choices available:


  • Alternative Depreciation - The slowest recovery method, and useful when assets are purchased in a year with little or no tax liability, thereby preserving the deduction for later years when income (and thereby tax liability) has risen.
  • Modified Accelerated Cost Recovery (MACRS) - The default option, which front-loads the deduction toward the first two or three years, tapering off toward the end.
  • Section 179 - Code Section 179 allows qualifying taxpayers to deduct a portion of assets in the year of purchase, subject to some restrictions. Over the past several years, the restrictions on this form of depreciation have been lessened considerably. The Sec. 179 expense limit currently stands at $500,000. Numerous restrictions apply to this code section, so always plan carefully.
  • Special Depreciation Allowance ("Bonus" depreciation) - Originally introduced as an economic stimulus after the 9/11 terrorist attacks, this form of depreciation has also been expanded over the ensuing years. Under this provision, first-use assets (i.e. brand new, not "new to you") qualify for a 50% upfront deduction if placed in service before 9/8/10 and a 100% deduction from 9/9/10 to the end of 2011. With fewer restrictions than Section 179, this provision has become a powerful tool for business owners.

A few further notes regarding depreciation: While Section 179 is an election made asset by asset, Bonus Depreciation applies by default (you must elect out if preferred) and to each asset class. For example, all 5-year assets, all 7-year assets, etc. It is also important to understand that depreciation can be subject to recapture if the asset is sold for a price higher than its remaining undepreciated basis. Think of it this way: If you fully deduct an asset and later sell it, the sale price becomes taxable income in order to bring the prior depreciation deduction back in line - this is referred to as "depreciation recapture." On the other hand, if you sell an asset for less than its remaining basis you can deduct that balance in full. So, if you originally purchased an asset for $10,000 and have taken $6,000 of depreciation deductions, any sale price below $4,000 (the remaining cost basis) generates a deductible loss and any sale price above $4,000 generates depreciation recapture. A sale price above the original $10,000 purchase price would generate $6,000 of depreciation recapture and capital gain on the rest. The IRS has devised a special form of torture called Form 4797 to calculate all this.

Depreciation can certainly be difficult to comprehend, but as long as you understand the basic premise you can always brush up on the latest rules. Once you do that, you will have an extremely versatile and powerful tool in your tax-saving toolbox.