What is MACRS Depreciation?
MACRS (the full form is Modified Accelerated Cost Recovery System) is a depreciation method for tax purposes used in the United States, and it allows for taking a higher depreciation deduction in the earlier years and less in the later years. It aims to maximize deductions using accelerated depreciation to encourage capital investments. However, MACRS depreciation tables are not advisable for depreciation expenses for audited financial statements as these rules ignore the useful life of the asset and salvage value.
The businesses hence, need to maintain separate books for tax and accounting purposes for depreciation differences.
IRS MACRS Depreciation Calculation Schedule
To select the correct depreciation rate, one must follow the below based on IRS Modified Accelerated Cost Recovery System MACRS schedule,
#1 – Classification of Asset Property
E.g., computer equipment is classified as 5-year property, office furniture is classified as 7-year property, residential rental property is classified as 27.5-year property, and non-residential real property is classified as 39-year property.
#2 – Selection of the Depreciation Method
Small business owners/certain owners may want to consider taking a lower tax deduction in the early years if they expect business profits to increase in later years or want to show higher profits in earlier periods. Generally, it is better to choose the higher depreciation rates in the earlier years for maximum tax savings.
There are two types of depreciation systems available, General Depreciation System (GDS) and Alternative Depreciation System (ADS). Generally, GDS is used unless specifically law mentions using ADS.
#3 -The Period when the Asset was Placed & Disposed of Service
This principle establishes when the useful life of an asset begins and ends. It determines the number of months for which a tax deduction can be claimed in the year when the asset is placed for use and the year it uses ends.
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There are 3 types of conventions for the period:
| Convention Types | Mid-month | Mid-quarter | Half-year | |||
| Property is placed in service or disposed of service. | in the mid of the month | in the midpoint of the quarter | the midpoint of the year | |||
| Applicability | Non-residential real property, residential real property, and any railroad grading or tunnel bore only. | When the mid-month convention does not apply, and total depreciable property placed in service or disposed of during the last 3 months is more than 40% of the total depreciable bases in service during the entire year; | When neither the mid-month convention nor the mid-quarter are applicable; | |||
| The tax deduction is limited to | The half-month of depreciation in the month the property was placed/ stopped in service. | To 1.5 months of depreciation in the month, the property was placed/ stopped in service. | 6 months of depreciation in the month the property was placed/ stopped in service. |
MACRS Depreciation Methods
Based on the IRS, there are four MACRS depreciation methods. Three of them cover in the GDS system and the last method under the ADS system.
#1 – 200% Declining Balance Method (GDS)
It means the depreciation rate is double the straight-line depreciation rate and provides the highest tax deduction during the initial years and then changes to the straight-line method when that method provides an equal or higher deduction.
#2 – 150% Declining Balance Method (GDS)
The depreciation method provides a greater depreciation rate of 150% more than the straight-line method. It then changes to the straight-line depreciation amount when that method provides an equal or greater deduction.
#3 – Straight Line Method (SLM) Over a GDS Recovery Period
SLM Depreciation method allows for a deduction of the same amount of depreciation every year except the first and last year of service.
#4 – Straight Line Method (SLM) Over an ADS Recovery Period
This method is similar to the above SLM method. However, this method is specifically for the mentioned properties that have been used for less than 50% of the time for business. Hence, the depreciation schedules generally have longer depreciation periods for a property.
Examples of MACRS Depreciation Calculation
Example #1
A machine with a life of 7 years is purchased for USD 5000 and placed into service on January 1. Based on the steps mentioned above,
- Classification of an asset – it’s a 7-year property
- Selection of depreciation method – Half-year convention, since:
- It isn’t qualified for assets mentioned under mid-month convention &
- It was purchased in the last quarter of the tax year to qualify for the mid-quarter convention.
- As the asset is considered to be “non-farm” 7-year properties, GDS using the 200% DB method is considered.
- The period when the asset was placed & disposed of service: Was placed in service on January 1, i.e., 1st
Using the rates mentioned by IRS, for a 7-year property gives us a depreciation rate of 14.29% for year 1 based on a 200% declining balance.
$5000 X 14.29% = 714.5
Example #2
Computer with a life of 5 years is purchased for USD 5000 and placed into service on April 1. Based on the steps mentioned above,
- Classification of asset property – it’s a 5-year property
- Selection of depreciation method – Half-year convention, since:
- It isn’t qualified for assets mentioned under mid-month convention &
- It was purchased in the last quarter of the tax year to qualify for the mid-quarter convention.
- As the asset is considered to be “nonfarm” 5-year properties, GDS using the 200% DB method is considered.
- The period when the asset was placed & disposed of service: Was placed in service on April 1, i.e., 2nd
Using the rates mentioned by the IRS for a 5-year property gives us a depreciation rate of 20% for year 1 based on a 200% declining balance.
$5000 X 20% = 1000
Example #3
ABC recently installed office furniture at the cost of USD 100 mn, and it was put to use on May 30, 2015. The company’s year-end is December 31.
The calculation of MACRS Depreciation is performed in the following steps:
- Classification of asset property – it’s 5-year property.
- Selection of depreciation method – Since the property does not fall into mid-month or mid-quarter convention, the half-year convention is relevant & the organization can choose either the 150% or 200% declining balance method.
- The period when the asset was placed & disposed of service: Was placed in service on May 1, i.e., 2nd quarter.
Depreciation
The depreciation based on Modified Accelerated Cost Recovery System(MACRS) is recognized in the company’s income tax return and used to determine taxable income by factoring in any tax credits and deductions that can be claimed on the property. Putting all together, classification & cost of asset, depreciation method and the period when the asset was placed into service determines the Modified Accelerated Cost Recovery System (MACRS).
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