Tractors and laptops get old, just like their owners. U.S. tax law recognizes that equipment used for a business — farm machinery, computers, trucks and tools — has a limited "useful life." Depreciation lets business owners deduct a percentage of the original cost of an item over its lifetime, rewarding investment and covering some of costs of maintaining older equipment.
Depreciation can be a huge tax advantage for small business owners, if — and that's a big if — you can make sense of the IRS depreciation tables. The depreciation tables spell out exactly how much you can deduct each year for different classes of business property. At first glance, the tables make about as much sense as the box score of a cricket match. But it all becomes clear after you understand some important tax terminology.
For each piece of business property you want to depreciate, you need to answer the following questions in order to use the depreciation tables:
- Which depreciation system applies?
- What is the property class?
- When was the item placed in service?
- What is the basis amount (cost)?
- What is the recovery period?
- Which depreciation convention applies?
- Which depreciation method applies?
The entire depreciation process is ruled by the Modified Accelerated Cost Recovery System (MACRS). MACRS itself is divided into two separate systems of depreciation: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). In all but a few rare cases — equipment used outside of the country, for example — GDS is the depreciation system that applies.
The IRS has divided every imaginable type of business property — from race horses to tugboats — into nine classes. Each class is named for its useful lifetime. Here are the nine classes and examples of the types of property they cover:
- 3-year property – race horses, rent-to-own property
- 5-year property – automobiles, computers
- 7-year property – office furniture, agricultural machinery
- 10-year property – boats, fruit trees
- 15-year property – restaurants, gas stations
- 20-year property – farm buildings, municipal sewers
- 25-year property – water treatment facilities
- Residential rental property – rental apartments or homes
- Nonresidential real property – office buildings or stores
If you want to look up the property class of just about any business property, browse through "Appendix B" of IRS Publication 946: How to Depreciate Property.
Keep reading for further instructions on how to decipher the IRS depreciation tables.
Calculating the Depreciation Deduction
You still need to collect a few more pieces of information before you're ready to use the IRS depreciation tables.
Placed in Service Date
With depreciation, you can deduct a larger percentage of the cost of the item in the first year of service than the second year, even less the third year and so on. The depreciation tables make this clear, but it's important to record the month and year you first purchased and began using the business property.
If you use the item exclusively for business, then the "basis" is the cost of the property. If you only use the property 75 percent of the time for business, then the basis is 75 percent of the cost.
The recovery period is the total number of years you can depreciate a piece of business property and corresponds with the nine property classes above. So a 15-year property has a recovery period of 15 years. Residential rental property has a recovery period of 27.5 years and nonresidential real property can be depreciated for 39 years.
This one is about figuring out when the recovery period begins and ends. The simplest method is the half-year convention (HY), in which the depreciated item is said to be placed in service and disposed of at the midpoint of the year. Therefore, it will take four years to depreciate a three-year asset. The mid-quarter convention is used when more than 40 percent of all depreciable property is placed into service during the last months of the tax year. The mid-month convention is reserved for real estate and railroad property.
Yes, this is somehow different than the depreciation "system" or the depreciation "convention." There are three different depreciation methods under the more common GDS system:
- 200 percent declining balance method – provides a greater deduction benefit in the first few years by doubling the percentage deducted each year. This is useful for property like cars and trucks that lose value quickly
- 150 percent declining balance method – also provides greater benefits in the earlier years of the recovery period
- Straight line method – provides equal deductions during each year of the recovery period except the first and last years
The good news is that you don't have to decide for yourself which method to use. Table 4-1 of IRS Publication 946 matches each depreciation method with specific classes of depreciable property.
Next, we'll dive into the depreciation tables themselves.
Using the IRS Depreciation Tables
OK, collecting all of that information was the hard part. Now it's time to figure out which percentage table to use. Again, not difficult — just reference "Appendix A" of IRS Publication 946. Plug in your system, method, recovery period, convention and so forth, and the chart will tell you which table to use, from A-1 to A-20.
The tables themselves are remarkable easy to use. There are vertical columns for each property class (3-year, 5-year, etc.) and horizontal rows for each year of the recovery period. Choose the class and recovery year and you'll find the percentage of the property's basis (cost) that you can deduct for that year.
Of course, if all of this talk of tables and conventions seems a little overwhelming, you can always use tax preparation software to run all of the numbers for you. Just don't overlook the potential tax savings of depreciation if you run a small business.
For lots more information about tax deductions and running a successful small business, check out the related HowStuffWorks articles on the next page.
Author's Note: How to Use IRS Depreciation Tables
There is a reason why millions of taxpayers use tax preparation software or an actual flesh-and-blood tax preparer to help file their income tax. All of the rules and definitions and calculations can be mind-numbingly complex. But I've found that the IRS really puts some thought into their posted instructions for each form, including helpful real-life examples of tax situations to illustrate each rule. Still, if your tax situation is complicated (home business, rental property, self-employed) it's worth having another set of eyes on your return — virtual or otherwise — to avoid making a costly mistake.
- IRS. "Publication 946: How to Depreciate Property." Jan. 28, 2014 (Nov. 21, 2014) http://www.irs.gov/pub/irs-pdf/p946.pdf