Quirky Depreciation Methods

June 5, 2019

Depreciation (and amortization for intangible property) is a central concept in accounting. Sometimes, depreciation is straightforward and makes intuitive sense. Other times, however, you really have to wonder who in the world came up with the particulat methodology. In this blog post, we’re going to look at some of the more quirky depreciation methods and try to understand why they might be helpful.

Measuring a Decline in Value

Simply stated, depreciation is the decline in value of an asset as a result of wear and tear. And since taxpayers get to take a tax deduction to offset a decline in an asset’s value (when it’s held for a business or investment purpose), measuring the amount of that decline is important.

We’ve referenced this in different contexts, including in Sec. 1031 exchanges. Depreciation often comes into play in the context of Sec. 1031 because taxpayers may face depreciation recapture following an outright sale. Accordingly, we should look at some of the various depreciation methods used in accounting to calculate depreciation deductions.

As it turns out, there is an almost mind-boggling range of methods we can use to calculate these deductions, some more quirky than others. Within this range, certain methods are more common than others, but all of them may be desirable in a given situation.  Let’s start our review with the method which is by far the most common – the straight-line method – and then work through some of the others. 

Straight-Line Depreciation

As mentioned, the straight-line method is undoubtedly the most common method we use to account for depreciation. Not surprisingly, it is also the simplest method. The straight-line method simply takes the original value (or cost basis) of a given asset, subtracts its residual or salvage value, and then divides the remainder according to the asset’s useful life. The final number (or quotient) is the yearly or annual depreciation deduction available to the asset’s owner.

Let’s consider an example. Suppose you purchase a car for business purposes at a price of $20,000. This vehicle has a salvage value of $3,000 and a useful life of 10 years. After 10 years, the car will have a value of $3,000, and so you would be depreciating a total of $17,000 over 10 years. Hence, you simply divide $17,000 by 10 years to arrive at a yearly deduction of $1,700. 

Residual Value

Residual value or salvage value means the value that the asset has at the end of its useful life. This makes sense because most assets will still have some value even after a long period of frequent use. Again, this method is the most common and the most straightforward. The straight-line method is based on the notion that an asset’s value declines stably over the course of its life. That’s why the depreciation deductions remain consistent over its depreciable life. In this way, the straight-line method is different from other methods which we will discuss. Unlike the straight-line method, the other depreciation methods assume that an asset declines unevenly in value and that depreciation deductions should account for this uneven decline.

Sum-of-Years-Digits Method 

In contrast to the straight line method, the sum-of-years-digits method (SYD) depreciates a given asset unevenly over the course of its useful life. So it tweaks a basic assumption of the straight line method. That is, the SYD method assumes that an asset is more valuable in the early years of its useful life, than in its later years. The formula for determining SYD depreciation schedule is as follows: Depreciable base x (remaining useful life / sum of years digits). In this equation, depreciable base equals the original cost of the asset, minus its salvage value. Sum of years digits means the sum of the individual digits preceding the total number of years of an asset’s useful life.

Let’s look at another example. Suppose we have an asset with an original cost of $2,000 and a salvage value of $200. If that asset has a useful life of 6 years, then we calculate its sum of years digits by doing the following: 6 + 5 + 4 + 3 + 2 + 1 = 21. So the asset has a sum of years digits of 21. The SYD depreciation schedule is calculated as follows: $1,800 (depreciable base) x 6/21 = $514.30 for the first year. Then, for the second year, the fraction 5/21 is used to calculate the next deduction.

Units-of-Production Depreciation

Yet another depreciation method is based on the number of widgets it produces in a given year. Called units-of-production depreciation, this method calculates annual depreciation deductions with reference to the expected number of units to be produced. The formula is as follows: annual depreciation deduction = (cost – salvage value / estimated total production) x actual production. Ultimately, the total depreciation taken will equal the original cost minus the salvage value.

Let’s look at an example: suppose we have a total equipment cost of $90,000, a salvage value of $15,000 and expected production of 8,000 units. To calculate yearly depreciation, we would need the actual production for a given year. In the first year, let’s suppose that number is 1,200 units. For the first year, then, the annual deduction would be $11,250. The math works out as follows: ($90,000 – $15,000 / 8,000) x 1,200 units = $11,250. In the next year, and in years to follow, you base the depreciation deduction on the number of units produced in those years to arrive at an appropriate annual deduction.

Call Our Tax Attorneys in NYC For Help

Confusing? It sure can be! But bits of information like these are why the resources provided by Mackay, Caswell & Callahan, P.C., are so valuable. Not only do we help resolve back taxes and provide other representation, we also want to assist our clients with lawful tax avoidance strategies. As we’ve said before, lowering your tax burden is the first step toward preventing tax problems. If you do happen to fall into back tax trouble, however, we can help. One of our top New York City tax attorneys is ready to assist you today.

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[…] as well as elaborate strategies such as the loans to avoid gift tax. We’ve even looked at various depreciation methodologies. In our quest to assist our readers and prospective clients, we’re always on the lookout for new […]

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The Benefits of Cost Segregation – Mackay, Caswell & Callahan, P.C. 4 years ago

[…] as well as elaborate strategies such as the loans to avoid gift tax. We’ve even looked at various depreciation methodologies. In our quest to assist our readers and prospective clients, we’re always on the lookout for new […]

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