Other Methods of Depreciation

Topics - This chapter discusses:

  • How to figure the deduction

  • Methods to use

  • How to change methods

  • Dispositions

Useful Items - You may want to see:

Publication

  • 544 Sales and Other Dispositions of Assets

  • 551 Basis of Assets

  • 583 Starting a Business and Keeping Records

  • 946 How To Depreciate Property

Form (and Instructions)

  • 3115 Application for Change in Accounting Method

  • 4562 Depreciation and Amortization

  • Schedule C (Form 1040) Profit or Loss From Business

If your property is being depreciated under ACRS, you must continue to use rules for depreciation that applied when you placed the property in service. If your property qualified for MACRS, you must depreciate it under MACRS. See Publication 946.

However, you cannot use MACRS for certain property because of special rules that exclude it from MACRS. Also, you can elect to exclude certain property from being depreciated under MACRS. Property that you cannot depreciate using MACRS includes:

  1. Intangible property,

  2. Property you can elect to exclude from MACRS that you properly depreciate under a method that is not based on a term of years,

  3. Certain public utility property,

  4. Any motion picture film or video tape,

  5. Any sound recording, and

  6. Certain real and personal property placed in service before 1987.

Intangible property.   You cannot depreciate intangible property under ACRS or MACRS. You depreciate intangible property using any other reasonable method, usually, the straight line method.

Note.

The cost of certain intangible property that you acquire after August 10, 1993, must be amortized over a 15-year period. For more information, see chapter 12 of Publication 535.

Public utility property.   The law excludes from MACRS any public utility property for which the taxpayer does not use a normalization method of accounting. This type of property is subject to depreciation under a special rule.

Videocassettes.   If you are in the videocassette rental business, you can depreciate those videocassettes purchased for rental. You can depreciate the cost less salvage value of those videocassettes that have a useful life over one year using either:
  • The straight line method, or

  • The income forecast method.

The straight line method, salvage value, and useful life are discussed later under Methods To Use. You can deduct in the year of purchase as a business expense the cost of any cassette that has a useful life of one year or less.

How To Figure the Deduction

Two other reasonable methods can be used to figure your deduction for property not covered under ACRS or MACRS. These methods are straight line and declining balance.

To figure depreciation using these methods, you must generally determine three things about the property you intend to depreciate. They are:

  1. The basis,

  2. The useful life, and

  3. The estimated salvage value at the end of its useful life.

The amount of the deduction in any year also depends on which method of depreciation you choose.

Basis

To deduct the proper amount of depreciation each year, first determine your basis in the property you intend to depreciate. The basis used for figuring depreciation is the same as the basis that would be used for figuring the gain on a sale. Your original basis is usually the purchase price. However, if you acquire property in some other way, such as inheriting it, getting it as a gift, or building it yourself, you have to figure your original basis in a different way.

Adjusted basis.   Events will often change the basis of property. When this occurs, the changed basis is called the adjusted basis. Some events, such as improvements you make, increase basis. Events such as deducting casualty losses and depreciation decrease basis. If basis is adjusted, the depreciation deduction may also have to be changed, depending on the reason for the adjustment and the method of depreciation you are using.

  Publication 551 explains how to figure basis for property acquired in different ways. It also discusses what items increase and decrease basis, how to figure adjusted basis, and how to allocate cost if you buy several pieces of property at one time.

Useful Life

The useful life of a piece of property is an estimate of how long you can expect to use it in your trade or business, or to produce income. It is the length of time over which you will make yearly depreciation deductions of your basis in the property. It is how long it will continue to be useful to you, not how long the property will last.

Many things affect the useful life of property, such as:

  1. Frequency of use,

  2. Age when acquired,

  3. Your repair policy, and

  4. Environmental conditions.

The useful life can also be affected by technological improvements, progress in the arts, reasonably foreseeable economic changes, shifting of business centers, prohibitory laws, and other causes. Consider all these factors before you arrive at a useful life for your property.

The useful life of the same type of property varies from user to user. When you determine the useful life of your property, keep in mind your own experience with similar property. You can use the general experience of the industry you are in until you are able to determine a useful life of your property from your own experience.

Change in useful life.   You base your estimate of useful life on certain facts. If these facts change significantly, you can adjust your estimate of the remaining useful life. However, you redetermine the estimated useful life only when the change is substantial and there is a clear reason for making the change.

Salvage Value

It is important for you to accurately determine the correct salvage value of the property you want to depreciate. You generally cannot depreciate property below a reasonable salvage value.

Determining salvage value.   Salvage value is the estimated value of property at the end of its useful life. It is what you expect to get for the property if you sell it after you can no longer use it productively. You must estimate the salvage value of a piece of property when you first acquire it.

  Salvage value is affected both by how you use the property and how long you use it. If it is your policy to dispose of property that is still in good operating condition, the salvage value can be relatively large. However, if your policy is to use property until it is no longer usable, its salvage value can be its junk value.

Changing salvage value.   Once you determine the salvage value for property, you should not change it merely because prices have changed. However, if you redetermine the useful life of property, as discussed earlier under Change in useful life, you can also redetermine the salvage value. When you redetermine the salvage value, take into account the facts that exist at the time.

Net salvage.   Net salvage is the salvage value of property minus what it costs to remove it when you dispose of it. You can choose either salvage value or net salvage when you figure depreciation. You must consistently use the one you choose and the treatment of the costs of removal must be consistent with the practice adopted. However, if the cost to remove the property is more than the estimated salvage value, then net salvage is zero. Your salvage value can never be less than zero.

Ten percent rule.   If you acquire personal property that has a useful life of 3 years or more, you can use an amount for salvage value that is less than your actual estimate. You can subtract from your estimate of salvage value an amount equal to 10% of your basis in the property. If salvage value is less than 10% of basis, you can ignore salvage value when you figure depreciation.

Methods To Use

Two methods of depreciation are the straight line and declining balance methods. If ACRS or MACRS does not apply, you can use one of these methods. The straight line and declining balance methods discussed in this section are not figured in the same way as straight line or declining balance methods under MACRS.

Straight Line Method

Before 1981, you could use any reasonable method for every kind of depreciable property. One of these methods was the straight line method. This method was also used for intangible property. It lets you deduct the same amount of depreciation each year.

To figure your deduction, determine the adjusted basis of your property, its salvage value, and its estimated useful life. Subtract the salvage value, if any, from the adjusted basis. The balance is the total amount of depreciation you can take over the useful life of the property.

Divide the balance by the number of years remaining in the useful life. This gives you the amount of your yearly depreciation deduction. Unless there is a big change in adjusted basis, or useful life, this amount will stay the same throughout the time you depreciate the property. If, in the first year, you use the property for less than a full year, you must prorate your depreciation deduction for the number of months in use.

Example.

In April 1994, Frank bought a franchise for $5,600. It expires in 10 years. This property is intangible property that cannot be depreciated under MACRS. Frank depreciates the franchise under the straight line method, using a 10-year useful life and no salvage value. He takes the $5,600 basis and divides that amount by 10 years ($5,600 ÷ 10 = $560, a full year's use). He must prorate the $560 for his 9 months of use in 1994. This gives him a deduction of $420 ($560 ÷ 9/12). In 1995, Frank can deduct $560 for the full year.

Declining Balance Method

The declining balance method allows you to recover a larger amount of the cost of the property in the early years of your use of the property. The rate cannot be more than twice the straight line rate.

Rate of depreciation.   Under this method, you must determine your declining balance rate of depreciation. The initial step is to:
  1. Divide the number 1 by the useful life of your property to get a straight line rate. (For example, if property has a useful life of 5 years, its normal straight line rate of depreciation is ⅕, or 20%.)

  2. Multiply this straight line rate by a number that is more than 1 but not more than 2 to determine the declining balance rate.

Unless there is a change in the useful life during the time you depreciate the property, the rate of depreciation generally will not change.

Depreciation deductions.   After you determine the rate of depreciation, multiply the adjusted basis of the property by it. This gives you the amount of your deduction. For example, if your adjusted basis at the beginning of the first year is $10,000, and your declining balance rate is 20%, your depreciation deduction for the first year is $2,000 ($10,000 ÷ 20%). To figure your depreciation deduction in the second year, you must first adjust the basis for the amount of depreciation you deducted in the first year. Subtract the previous year's depreciation from your basis ($10,000 - $2,000 = $8,000). Multiply this amount by the rate of depreciation ($8,000 ÷ 20% = $1,600). Your depreciation deduction for the second year is $1,600.

  As you can see from this example, your adjusted basis in the property gets smaller each year. Also, under this method, deductions are larger in the earlier years and smaller in the later years. You can make a change to the straight line method without consent.

Salvage value.   Do not subtract salvage value when you figure your yearly depreciation deductions under the declining balance method. However, you cannot depreciate the property below its reasonable salvage value. Determine salvage value using the rules discussed earlier, including the special 10% rule.

Example.

If your adjusted basis has been decreased to $1,000 and the rate of depreciation is 20%, your depreciation deduction should be $200. But if your estimate of salvage value was $900, you can only deduct $100. This is because $100 is the amount that would lower your adjusted basis to equal salvage value.

Income Forecast Method

The income forecast method requires income projections for each videocassette or group of videocassettes. You can group the videocassettes by title for making this projection. You determine the depreciation by applying a fraction to the cost less salvage value of the cassette. The numerator is the income from the videocassette for the tax year and the denominator is the total projected income for the cassette. For more information on the income forecast method, see Revenue Ruling 60-358 in Cumulative Bulletin 1960, Volume 2, on page 68.

How To Change Methods

In some cases, you may change your method of depreciation for property depreciated under a reasonable method. If you change your method of depreciation, it is generally a change in your method of accounting. You must get IRS consent before making the change. However, you do not need permission for certain changes in your method of depreciation. The rules discussed in this section do not apply to property depreciated under ACRS or MACRS.

For information on ACRS elections,see Revocation of election, in chapter 1 under Alternate ACRS Method.

Change to the straight line method.   You can change from the declining balance method to the straight line method at any time during the useful life of your property without IRS consent. However, if you have a written agreement with the IRS that prohibits a change, you must first get IRS permission. When the change is made, figure depreciation based on your adjusted basis in the property at that time. Your adjusted basis takes into account all previous depreciation deductions. Use the estimated remaining useful life of your property at the time of change and its estimated salvage value.

  You can change from the declining balance method to straight line only on the original tax return for the year you first use the straight line method. You cannot make the change on an amended return filed after the due date of the original return (including extensions).

  When you make the change, attach a statement to your tax return showing:
  1. When you acquired the property,

  2. Its original cost or other original basis,

  3. The total amount claimed for depreciation and other allowances since you acquired it,

  4. Its salvage value and remaining useful life, and

  5. A description of the property and its use.

  After you change to straight line, you cannot change back to the declining balance method or to any other method for a period of 10 years without written permission from the IRS.

Changes that require permission.   For most other changes in method of depreciation, you must get permission from the IRS. To request a change in method of depreciation, file Form 3115. File the application within the first 180 days of the tax year the change is to become effective. In most cases, there is a user fee that must accompany Form 3115. See the instructions for Form 3115 to determine if a fee is required.

Changes granted automatically.   The IRS automatically approves certain changes of a method of depreciation. But, you must file Form 3115 for these automatic changes.

  However, IRS can deny permission if Form 3115 is not filed on time. For more information on automatic changes, see Revenue Procedure 74-11, 1974-1 C.B. 420.

Changes for which approval is not automatic.   The automatic change procedures do not apply to:
  1. Property or an account where you made a change in depreciation within the last 10 tax years (unless the change was made under the Class Life System),

  2. Class Life Asset Depreciation Range System, and

  3. Public utility property.

  You must request and receive permission for these changes. To make the request, file Form 3115 during the first 180 days of the tax year for which you want the change to be effective.

Change from an improper method.   If the IRS disallows the method you are using, you do not need permission to change to a proper method. You can adopt the straight line method, or any other method that would have been permitted if you had used it from the beginning. If you file your tax return using an improper method, but later file an amended return, you can use a proper method on the amended return without getting IRS permission. However, you must file the amended return before the filing date for the next tax year.

Dispositions

Retirement is the permanent withdrawal of depreciable property from use in your trade or business or for the production of income. You can do this by selling, exchanging, or abandoning the item of property. You can also withdraw it from use without disposing of it. For example, you could place it in a supplies or scrap account. Retirements can be either normal or abnormal depending on all facts and circumstances. The rules discussed next do not apply to MACRS and ACRS property.

Normal retirement.   A normal retirement is a permanent withdrawal of depreciable property from use if the following apply:
  1. The retirement is made within the useful life you estimated originally, and

  2. The property has reached a condition at which you customarily retire or would retire similar property from use.

A retirement is generally considered normal unless you can show that you retired the property because of a reason you did not consider when you originally estimated the useful life of the property.

Abnormal retirement.   A retirement can be abnormal if you withdraw the property early or under other circumstances. For example, if the property is damaged by a fire or suddenly becomes obsolete and is now useless.

Gain or loss on retirement.   There are special rules for figuring the gain or loss on retirement of property. The gain or loss will depend on several factors. These include the type of withdrawal, if the withdrawal was from a single property or multiple property account, and if the retirement was normal or abnormal. A single property account contains only one item of property. A multiple property account is one in which several items have been combined with a single rate of depreciation assigned to the entire account.

Sale or exchange.   If property is retired by sale or exchange, you figure gain or loss by the usual rules that apply to sales or other dispositions of property. See Publication 544.

Property not disposed of or abandoned.   If property is retired permanently, but not disposed of or physically abandoned, you do not recognize gain. You are allowed a loss in such a case, but only if the retirement is:
  1. An abnormal retirement,

  2. A normal retirement from a single property account in which you determined the life of each item of property separately, or

  3. A normal retirement from a multiple property account in which the depreciation rate is based on the maximum expected life of the longest lived item of property and the loss occurs before the expiration of the full useful life. However, you are not allowed a loss if the depreciation rate is based on the average useful life of the items of property in the account.

  To figure your loss, subtract the estimated salvage or fair market value of the property at the date of retirement, whichever is more, from its adjusted basis.

Special rule for normal retirements from item accounts.   You can generally deduct losses upon retirement of a few depreciable items of property with similar useful lives, if:
  1. You account for each one in a separate account, and

  2. You use the average useful life to figure depreciation.

However, you cannot deduct losses if you use the average useful life to figure depreciation and they have a wide range of useful lives.

  If you have a large number of depreciable property items and use average useful lives to figure depreciation, you cannot deduct the losses upon normal retirements from these accounts.

Abandoned property.   If you physically abandon property, you can deduct as a loss the adjusted basis of the property at the time of its abandonment. However, your intent must be to discard the property so that you will not use it again or retrieve it for sale, exchange, or other disposition.

Basis of property retired.   The basis for figuring gain or loss on the retirement of property is its adjusted basis at the time of retirement, as determined in the following discussions.

Single item accounts.   If an item of property is accounted for in a single item account, the adjusted basis is the basis you would use to figure gain or loss for a sale or exchange of the property. This is generally the cost or other basis of the item of property less depreciation. See Publication 551.

Multiple property account.   For a normal retirement from a multiple property account, if you figured depreciation using the average expected useful life, the adjusted basis is the salvage value estimated for the item of property when it was originally acquired. If you figured depreciation using the maximum expected useful life of the longest lived item of property in the account, you must use the depreciation method used for the multiple property account and a rate based on the maximum expected useful life of the item of property retired.

  You make the adjustment for depreciation for an abnormal retirement from a multiple property account at the rate that would be proper if the item of property was depreciated in a single property account. The method of depreciation used for the multiple property account is used. You base the rate on either the average expected useful life or the maximum expected useful life of the retired item of property, depending on the method used to determine the depreciation rate for the multiple property account.


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