Depreciation, or Cost Recovery
An asset used in the taxpayer's trade or business which has a life of one year or less is
simply deducted when computing business income or loss for the year. However, if the
asset's life is longer (e.g., equipment, buildings), the cost must be "recovered" through a
"stream" of deductions over the asset's life, or "recovery period." These deductions are
commonly called depreciation deductions because they reflect the fact that the asset is
declining in value (depreciating, wearing out) over time. Technically, the deductions are "cost
recovery" deductions because the taxpayer is recovering his cost of the asset (through the
deductions). Thus, the current depreciation system is called "MACRS" which stands for the
Modified Accelerated Cost Recovery System.
Note that assets not used in a trade or business (or for the production of income, i.e.,
investment assets) are neither deductible nor depreciable. These are simply "personal"
assets such as your home, your personal car, etc., which have no impact on your tax
situation. Assets which are depreciable include "personalty" and real estate (realty) other
than land (land is not depreciable). Personalty is a legal term meaning assets which are not
real estate. Typical depreciable personalty is equipment, furniture, machinery, a truck or car
used in the business, etc.
How to arrive at the deduction. Two pieces of information are needed to determine the
depreciation deduction. The first is the "class" or recovery period for the property. For example, basic
automobiles used in the business are in the 5-year class (regardless of the type of car: even a Volvo or
Mercedes which should last well over 5 years is a 5-year asset). Office furniture and equipment generally
falls into the 7-year class. The second piece of information is the "method" of depreciation. Most commonly,
the method used is the "double declining balance" method, which is already worked into the depreciation
tables. See the tables in your text. These tables make the depreciation area fairly simple.
For example, a 7-year item of property is depreciable over an 8-year period according to the
following percentages in the table: 14.29%, 24.49%, 17.49%, 12.49%, 8.93%, 8.92%, 8.93%, and 4.46%.
Note that except for the first year, the deductions for the first few years are higher. This favors the taxpayer
who wants the tax benefits as soon as possible. That's why the system is called "accelerated."
So a machine placed in service in Year 1 with a basis (cost) of $100,000, would
generate a depreciation deduction of $14,290 in Year 1 (14.29% X $100,000); $24,490 in
Year 2, and so on.
If you don't use the "Table" method, you will generally be using "straight line." This
means the basis is spread evenly over the depreciation period. A five year asset will get
20% a year for five years. However, because the mid-year convention applies (as discussed
immediately below), the asset is treated as placed in service in the middle of the first year,