Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation

Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation

based on a number of factors, including the expected rate of physical depreciation of its asset and the effect on reported income. For federal income tax purposes, however, businesses are limited by law with regard to both the depreciation method and the period of time over which an asset can be depreciated.

The current depreciation tax laws are the result of an ongoing trend to create more uniformity in depreciation methods among business tax- payers while at the same time simplifying the calculations and allowing accelerated depreciation and shorter asset lives.

Currently, the two methods of depreciation available to business taxpayers are an accelerated method and straight-line. The accelerated method, referred to as the modified accelerated cost recovery system (MACRS), has four features:

1. The depreciation rate used each year is either 150% or 200% of the straight-line rate (referred to as 150 declining balance (DB) and 200 DB, respectively), depending on the type of property, applied against the undepreciated cost of the asset. Since the rate is applied against a

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declining amount, this method is a declining balance method, but not the same declining balance method as that used for financial statement reporting purposes.

2. The salvage value of the asset is ignored; so the depreciable cost is the original cost and the asset’s value is depreciated to zero.

3. The half-year convention is used on most property, that is, a half-year of depreciation is taken in the year the asset is acquired, no matter whether it is owned for one day or 365 days.

4. The depreciation method is switched to the straight-line method when straight-line depreciation produces a higher depreciation expense than the accelerated method.

Because the MACRS is an accelerated method, it yields greater depreciation expenses in earlier years and thus reduces taxable income and taxes relative to straight-line depreciation. However, the law allows some firms to use straight-line depreciation if they don’t have the income necessary to take advantage of the faster depreciation of the MACRS. The use of MACRS for tax purposes and straight-line for financial reporting purposes, which is often the case for U.S. corpora- tions, results in a difference in income for tax and financial accounting. This difference gives rise to deferred tax liabilities because actual taxes (calculated using MACRS depreciation) are less than reported taxes (calculated using straight-line depreciation) when MACRS results in a greater amount of depreciation, as in the earlier years of an asset’s life. 1

Congress (and the IRS) have taken much of the work out of calculating depreciation expenses for tax purposes. 2 Exhibit 5.4 outlines the deprecia- ble life for each class of assets and the depreciation rates used for assets of each classified life. First, as panel a shows, depreciable lives are assigned to the various classes of assets that might be used by businesses. Second, tables are provided showing the depreciation rates to be applied to the asset’s cost for each year in the life of each class of asset (panel b of Exhibit 5.4.)

Notice in panel b that each asset type is depreciated over its life plus one year: There are four years of depreciation for a 3-year asset, six years of depreciation for a 5-year asset, and so on. This is because of the half-year convention: Only half a year’s depreciation is used up at the start, leaving half a year’s depreciation to be taken after the asset’s “life” is over for tax purposes.

1 In Exhibit 5.4, for example, we see that most of the deferred tax liabilities arise from the depreciation of property, plant, and equipment.

2 There are occasional changes to this system. For example, for a limited period of time (2001 through 2005), businesses are entitled to an additional 30% depreciation in the

asset’s first year for qualifying assets (Job Creation and Worker Assistance Act of 2002).

Taxation

EXHIBIT 5.4 Modified Accelerated Cost Recovery System (MACRS)

Panel a. Classified Lives

3-year:

Tractor units, racehorses over two years old, special tools

5-year: Cars, light and heavy trucks, computer and peripheral equipment, semi-conductor manufacturing equipment 7-year:

Office furniture and fixtures, railroad property 10-year:

Means of water transportation, fruit trees, nut trees 15-year:

Municipal wastewater plants, depreciable land improvements, pipelines, service station buildings 20-year:

Farm buildings, municipal sewers 27.5-year: Residential rental property 31.5-year: Non-residential real property, such as elevators and escalators 50-year:

Railroad grading and tunnel bores

Panel b. Depreciation Rates for 3-Year, 5-Year, 7-Year, 10-Year, 15-Year, and 20-Year Classified Assets

Depreciation Rate (%)

Year 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year

2.231 These rates reflect depreciation calculated using the 200% (for 3-year, 5-year, 7-

year, and 10-year property) or 150% (for 15-year and 20-year property) declining- balance method, with a switch to straight-line, using the half-year convention.

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EXHIBIT 5.5 MACRS Depreciation of a $50,000 Truck, Using MACRS Rates

Year Depreciation Rate Depreciation Expense = Rate Times $50,000

Let’s see how depreciation expense is calculated using the informa- tion in Exhibit 5.5. Suppose a firm buys a truck for $50,000. According to panel a of the table, the truck has a 5-year class life. According to panel

b, the first year’s depreciation rate is 20%, the next year’s is 32%, and so on. The results of applying these rates to the cost of the truck over six years are shown in Exhibit 5.5. The total cost is recouped over the six years, with most of the depreciation expense taken in the earlier years.

From the perspective of a financial analyst, understanding current and expected depreciation rates is important because depreciation, while not itself a cash flow, affects a corporation’s taxes and hence its cash flows. If the corporation has a depreciation expense of $100 million and a 35% marginal tax rate, the benefit from the depreciation deduction for tax pur- poses is to reduce taxable income by $100 million and hence reduce taxes by 35% times $100 million, or $35 million. This reduction in taxes of $35 million is referred to as the depreciation tax-shield. Over the life of an asset, the total dollar amount of depreciation is the same regardless of the rate of depreciation. However, changes in depreciation rates affect the tim- ing of the depreciation tax-shield and hence their value today.