Depreciation Accounting for Taxes Under 26US Code?

depreciation accounting

What is depreciation?

An asset of the business is used for a period of its life. Therefore, adjusting the full or original costs in one year is neither prudent nor logical. Based on this, the depreciation meaning is simple as far as accounting is concerned. It means the decrease in the fair value of an asset in a year. Therefore only a portion of the original cost of the assets proportionate to the value decrease is allocated as an expense. In the balance sheet, the allocated value (depreciation for the year concerned) is reduced from the assets’ value to represent the original cost left to be allocated.

Section 167 of The Internal Revenue Code deals with the law on deprecation .

What is depreciation accounting for taxes?

The depreciation accounting facilitates businesses to record the real-time book value of tangible assets.The depreciation accounting , in general , is the recording the value of asset depreciation and revalue the cost basis of asset after adjusting the basis by reducing the value of depreciation .This is found out by accountants using one of the five types of depreciation methods available. What is unique about depreciation accounting is that the depreciation expense is computed every year when the said asset is in use by the business without incurring cash expense.So, the amount of depreciation does not represent any cash outflow. Instead, the computed depreciation expense is transferred to the accumulated depreciation.

Types of Depreciation Methods 

There are five methods of finding out depreciation amount of an asset employed in a business. These are :

#1 – Straight-Line Method (SLM)

As the name suggest , you find out the lid of an asset and then divide the cost basis of the asset minus salvage value . The salvage value means the money you get when you sell the asset after the expected life. For example , say a company XYZ bought a machinery for $1000 . The life expectancy of the said machinery , say is 10 years. Let us say , company estimates to get $50 when it sells the machinery in 11th year . The depreciation expense which has to be accounted for using the straight line method using the straight line method will be

$1,000 -$50 /10 = $95 .The depreciation accounting for depreciation expense every year using the starigt line method will be for $ 95

#2 – Declining Balance Method

Contrary to straight-line method , wherein the amount of depreciation charged profit remains same for all the years, in case of Declining Balance method , you apply a depreciation rate on the diminished asset value on the first day of year. It means, every year the Net Book Value ( or written down value) of an asset or value of asset on first day of the year is determined by reducing the depreciation value computed for earlier year.

Depreciation =( Net Book Value -salvage value) X Depreciation rate

#3 – Double Declining Balance Method

This method is similar to the declining balance method except that double depreciation rate is applied is double on the fixed asset’s balance value.

Depreciation =( Net Book Value -salvage value) X Twice of Depreciation rate

#4 – Units of Production Method

Under this method, first the unit production rate is found out and then depreciation expense for the year is found out by multiplying with units produced in a year.The units of production depreciation formula is: 

Unit Production Rate = (Original Value – Salvage Value) / Estimated Unit Production.

Depreciation = Nos oof units produced x Unit Production Rate

#5 – Sum-of-Years Digits Method or SYD Method

The sum of the years’ digits method or commonly known as SYD method is used to accelerate the recognition of depreciation. Under this method , acceluses the expected life and adds the digits for every year to give the final depreciation expense amount. Say, the useful life of the asset is 7 years. So, the sum of the years is obtained by adding up the year’s digits as 7+6+5+4+3+2+1 = 28

So rate of depreciation under SYD method will be as under :

1st year. 7/28= 25%; 2nd year 6/28= 21.4% 3rd year 5/28= 17.85%. likewise…..

Depreciation formula is = (Asset – Salvage Value) x Rate of depreciation

Is depreciation an expense?

The method is more appropriate than the more commonly-used straight-line depreciation if an asset depreciates more quickly or has greater production ca­pacity in its earlier years than it does as it ages.

Depreciation is the decrease in value, and it represents that much expense for the business in which the asset was used during the year. So, the depreciation is an expense for a year and is calculated using various methods of computing depreciation using The IRS notified depreciation rates for various business assets.

How depreciation is calculated?

There are many methods of computing depreciation like the Straight Line method, Double Declining Balance depreciation, Sum-of-the-year’s-digits depreciation and Units of production depreciation method. But, for tax purposes in the USA, the Modified Accelerated Cost Recovery System (MACRS) is the depreciation method. To compute deprecation expense for an asset of a business, under MACRS, you must know four essential ingredients:

  • What is the basis of assets used in business?
  • What is the class life of the asset?
  • When was the asset placed in Service?
  • Which method of depreciation to employ?

Let us discuss each one of the four requirements separately. Once you get all those inputs, you follow the 26 U.S. Code § 168, which provides law for the computation of depreciation for tax purposes. Under the Modified Accelerated Cost Recovery System (MACRS). the method, you compute the depreciation based on specific parameters -the basis of asset class life of assets and the MACRS rates notified by the IRS. The computation of depreciation is done for each asset in the year asset is placed in service and each subsequent year of its class life.

What is the basis of an asset for depreciation calculation?

A basis of the asset is the original purchase price of the asset that includes sale tax, freight and installation expense. so when you compute the basis of asset, you must include the cash price. You must also include the interest paid on the loan taken to acquire the asset before you used the property.

What is the class life of the asset?

Every asset- building, machinery, or electronic equipment – has a life. In accountancy, the basis of assets is divided by the expected years of the asset’s life to get an amount that can be charged as depreciation expense for a year. So, a class life signifies the number of years over which an asset can be depreciated. The Internal Revenue Code has defined a specific class life for each type of asset used in business. You can get a full list of asset class life explaining property classes also commonly known as IRS depreciation tables published as  IRS Publication 946. Or the common business assets life and assets life business activities wise.

Is depreciation an operating expense?

Even though there is no cash expenditure every year for the associated depreciation expense claim, depreciation is an operating expense because the assets are used in the operation of the business. For this reason, the income statement is prepared after the reduction of depreciation expense. 

What is depreciation recapture & how does depreciation recapture work

When an asset is used for business, you are allowed depreciation as expense.This reduces taxable business income. Next year ,the basis of of the said asset gets reduced because of claim of deprecaition. Now, let us say the asset is sold for a gain , in that case the tax law provides that the total taxable gain which will be taxed are as under :

  1. Realized capital gains computed by sale consideration minus the cost basis
  2. Depreciation recapture means total accumulated depreciation claimed or realized capital gains whichever is more.

So, one can say that depreciation recapture is the portion of the gain attributable to the depreciation deductions previously claimed. The depreciation recapture is taxted as normal income and the tax rate is 25% for year 2022. Let us understand it with an example.

Let us say , Mr X owned a building for $1 million (excluding land ) that was used for his business for 10 years, during which he claimed total depreciation deduction of $400,000 .If he sold the building for $4 million , then the gains and taxability on sale of builing will be computed as below :

Long term Capital Gains (taxed at 0 to 20%)

Sale consideration. $4,000,000

Cost basis (10th Year ) [$1,000,000- $400,000)= $600,000

A) Long Term Capital gain= $4,000,000 minus $600,000 = $3,400,000 (taxd at rate applicable for LTCG)

B) depreciation Recapture

Total depreciation claimed x Depreciation Recapture Rate = $400,000 x25%=$100,000

Since realized gain is more than depreciation claimed earlier,the depreciation recapture amount will be taxed at normal rate of tax applicable to Mr X ( Not the LTCG rate)

Therefore , important to note that in case of assets that are used in business and on which we claim depreciation , when sold will create two kinds of gains which are taxable on different rate. Depreciation capture on normal rate and long term capital gains on a specific rates applicable to it.

Is 100% depreciation write off possible?

Answer is yes. Section 179 of the Internal Revenue Code providea anasset deduction scheme , often referred to as the first-year expense deduction. As per this law , you can decide to claim 100% depreciation in the very first year of use of the assets. For claiming the deduction of 100% depreciation under IRC 179 , following three conditions must be fulfilled

  1. You can not have depreciation deduction u/s 179 for more than $1,160,000 for tax year 2023 ($1,080,000 during tax year 2022.)
  2. There is a monetary limit of $2,890,000 on equipment purchases as of January 1, 2023 . (The amount was $2,700,000 for tax year 2022)
  3. The section 179 deduction starts phasing out , dollar for dolllar above $2,800,000.
  4. The taxpayer’s § 179 deduction for any taxable year may not exceed the taxpayer’s aggregate income from the active conduct of trade or business by the taxpayer for that year. 

What is bonus depreciation for 2022?

Tax Cuts & jobs Act introduced this concept of “bonus depreciation under which a business entity can deduct 100 to 20 percent of depreciation expense on certain specified assets purchased and used within a period. Just note that the last date for buying assets for 100% depreciation is 1st January 2023. There are many other conditions and bonus depreciation conditions are different than section 179 deuction . Read the post Bonus depreciation vs Section 179 Deduction

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