MACRS Depreciation

What Is the Modified Accelerated Cost Recovery System (MACRS)?

MACRS is a tax depreciation method for tangible property, assigning specific recovery periods to assets for tax deduction purposes.

Businesses can utilize depreciation to spread the cost of assets like buildings, equipment and machinery, vehicles, and furniture across the years they will be used. Most organizations use the straight-line technique to depreciate assets for internal accounting purposes.

On the other hand, the Internal Revenue Service or IRS compels most corporations to use the modified accelerated cost recovery system, or MACRS, when claiming depreciation on their tax returns.

Depreciation under the MACRS was adopted in 1986 to encourage enterprises to invest in depreciable assets by providing bigger depreciation deductions in the asset’s early years of useful life.

This differs from straight-line depreciation, which gives the company the same yearly deduction until the asset is fully depreciated. MACRS also lures investments for businesses by providing significant tax savings in the asset’s early years.

Automobiles, office furniture, heavy machinery, farm structures, fences, computing equipment, and other asset groups are all eligible for MACRS depreciation.

Additionally, the IRS modified dollar restrictions for section 179 deductions in 2022. The maximum section 179 expense deduction for tax years beginning in 2022 is $1,080,000.

The amount by which the cost of section 179 property used during the tax year exceeds $2,700,000 reduces this limit. Furthermore, for sport utility vehicles put into operation in tax years beginning in 2022, the maximum section 179 expense deduction is $27,000.

Depreciation Systems to Use with MACRS Depreciation

Under MACRS depreciation, there are two types of systems: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS).

The Alternative Depreciation System (ADS) is used to compute the depreciation of certain types of assets, often in specific circumstances.

The IRS mandates the use of the ADS, which often extends the amount of time over which an item is depreciated. As a result, the depreciation expense recorded each year is reduced.

However, the General Depreciation System (GDS) employs a diminishing balance to depreciate assets. The non-depreciated balance is applied to the depreciation rate in GDS. It uses a shorter recovery period than ADS.

Calculation Methods

There are four methods to calculate depreciation under the modified ACRS depreciation system, three of which fall under GDS, and one falls under ADS.

1. Two hundred percent declining balance method (GDS): It accelerates depreciation with a rate twice as high as the straight-line method. It allows for more tax deductions in the early years, and typically, the switch to the straight-line method occurs when it yields a smaller deduction
2. One hundred fifty percent declining balance method (GDS): This strategy accelerates the straight-line depreciation rate by 150 percent. When a larger or equal deduction is available, this technique, like the 200 percent method, reverts to the straight-line depreciation method
3. SLM over GDS: In the straight-line method over GDS, depreciation occurs at a consistent rate each year, except for the first and last years, when it may be adjusted
4. SLM over ADS Recovery Period: Although similar to the SLM over GDS technique, this one is only applicable to properties/assets that have been used for less than half of the business’s allocated period

calculating MACRS depreciation

Vehicles, office furniture, machinery, land improvements, computer equipment, and various other assets can all be depreciated under the MACRS. To calculate MACRS depreciation, the steps are:

1. Determine the basis

The depreciation basis of an asset is usually the price you pay for it. It can, however, also include extra costs associated with purchasing the item and preparing it for usage.

For example, if you spend $10,000 on manufacturing equipment and an additional $5,000 to have it shipped and set up, your depreciable basis is $15,000.

2. Determine the property’s class

MACRS categorizes assets based on their useful life. IRS Publication 946 offers examples of property classes:

• 3-year property: Tractors, Race courses (>2 years old), Rent-to-Own Property
• 5-year property: Automobiles, Buses, Cabs, Office equipment, Research property, Computers, Peripheral equipment, Breeding cattle, Dairy cattle, Appliances, Carpets, Furniture used in residential real estate transactions
• 7-year property: Office furniture, Fixtures, Railroad trucks, Agricultural machinery, Property with no class life, Natural gas collection lines
• 10-year property: Vessels, Barges, Agricultural structures, Trees/vines bearing fruits, Qualified small electric meter, Smart electric grid systems
• 15-year property: Restaurants, Land improvements, Municipal water treatment plants, Electricity transmission property (transmitting 69 or more kilovolts), Retail improvement property, Telephone distribution plant, Leasehold improvement property
• 20-year property: Farm buildings (excluding single-purpose agricultural structures), Municipal sewers (that cannot be classified under 25-year property)
• 25-year property: Municipal sewers, Property part of water distribution facilities
• 27.5-year property: Buildings (where >=80% of gross rental income comes from dwelling units)
• 39-year property: Office buildings, Stores, Warehouses (non-residential)

The 200 percent declining balance approach is used for three-year, five-year, seven-year, and ten-year properties. This means you deduct a percentage of the asset’s book value each year, typically twice the straight-line depreciation rate

3. Determine the date of placed-in-service

The date the property was placed in service is sometimes the same as when it was purchased, but it can also be different. When an asset is ready and available for use, it is said to be “in service.”

Suppose you buy a piece of equipment in December, but it doesn’t get delivered or installed until January. As a result, you cannot start deducting MACRS depreciation until January, even though you ideally purchased the equipment in December.

4. Determine which convention applies

The convention you adopt determines the number of months you can claim depreciation in the asset’s first year.

There are three conventions:

• The convention takes place in the middle of the month: Buildings are depreciated under MACRs utilizing the mid-month convention, which begins depreciating all property placed in service during the month at the halfway point. For example, if you buy a residential rental property on January 30, you can claim half a month’s depreciation in January.
• The convention takes place in the middle of the quarter: Unless the asset must employ the mid-month convention, the mid-quarter convention is applied for any property placed in service during the last three months of the tax year. For example, if your company’s year-end is December 31, you can claim 112 months of depreciation for any equipment installed in December.
• Convention for a half-year: Any property that does not need the use of the mid-month or mid-quarter convention can use the half-year convention. Under this convention, you can begin depreciating all property placed in operation during the tax year as of the year’s midpoint. So, if you buy a piece of equipment in January, you can depreciate it for a half-year that year.

5. Calculate MACRS depreciation

Now that you have all of the relevant information use the equation below to calculate the proportion of the asset’s basis that you can deduct in the first year.

1st Year Depreciation = Basis * (1 / Useful Life) * Depreciation Method * Depreciation Convention

The formula to use in the following years would be:

Depreciation for the following years = (Basis – Depreciation in Previous Years) * (1/Useful life) * Depreciation Method

For example, consider purchasing furniture for your newly renovated office worth $10,000, for which the half-year convention applies. Furniture is a 5-year property, so you must use the 200% declining balance method. For the first year, the depreciable amount would be:

$10,000 * ⅕ * 200% * 0.5 = $2,000

For the subsequent years, the amount would be

($10,000 - $2,000) * ⅕ * 200% = $3,200

Advantages of accelerated depreciation

The advantages are:

• It helps you reduce your start-up deductions: It can help you save money on start-up costs by raising the amount of money you can deduct during the first few years of your firm. This will allow you to lower your overall business tax debt, which means you will have more money to spend on marketing, equipment purchases, and expanding your business. You will have a better probability of succeeding in the market.
• It allows you to take a higher up-front deduction: Another significant benefit of accelerated depreciation is that it will enable you to take a larger deduction immediately, lowering your current tax expenses. This is especially useful if a new business is experiencing short-term cash flow issues.

• It works as a tax deferral: Thanks to this depreciation system’s higher deductions, your firm can defer a portion of its tax burden. If your firm is trying to lower the amount of taxes it owes, delaying tax debts with this strategy will give you more time before you have to pay the entire amount of your taxes.

disadvantages of accelerated depreciation

On the other hand, the disadvantages are:

• Lower future deductions can prove problematic for growing businesses: Accelerated depreciation does result in larger tax deductions initially by allowing higher upfront deductions, but it reduces deductions in future years. This can be an issue for a developing company whose revenue would push it into a higher tax bracket. Because your firm will be in a higher tax slab, accelerating deductions will leave you with fewer alternatives to minimize your taxes in the future.
• It is given topmost priority: Opponents claim this system has a blatant preference that permits corporations to deduct expenses before assets truly wear out. They claim that this can skew company decisions about what to invest, when, and how much to invest. Furthermore, the current system is claimed to be extremely old and overly complicated.
• It poses the risk of recaptured depreciation: You can sell a long-term property before it is rendered inert based on its schedule under accelerated depreciation, but if you sell it for more than its current accounting value, the profit will be considered as recaptured depreciation. Because the asset did not depreciate as quickly as predicted, the IRS will now take away your deductions, and your recovered depreciation gains will be taxed as income.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Accelerated Depreciation
• Alternative Depreciation System (ADS)
• Income Statement
• Straight Line Basis
• Types of Assets