Understanding Depreciation Deductions

June 24, 2019

One of the best ways to avoid falling into tax debt is to minimize one’s tax burden. At MCC, one of our principal areas of specialization is the resolution of back tax debt. Given that this is the case, tax minimization is something we’re quite familiar with. On our blog, we’ve discussed quite a few tax avoidance and tax minimization strategies. We’ve discussed the “loans to avoid gift taxes” strategy, for instance. Tax avoidance is perhaps most commonly occurs with deductions and credits. When a taxpayer takes a deduction, he or she is engaging in a form of legitimate tax avoidance. One of the most common types of deductions is the deduction for depreciation. Depreciation is a foundational concept in tax and accounting. Depending on the situation, deductions for depreciation can amount to considerable sums of money. 

In this post, we will discuss some of the essential facts of depreciation. We will first cover the basic concept of depreciation in the tax and accounting context, and then discuss the various methods of depreciation. Next, we will cover the difference between amortization and depreciation. Finally, we will conclude with a quick reference to depreciation recapture.  

Understanding the Basic Concept of Depreciation 

Depreciation refers to the wear and tear which naturally occurs to a given asset over time. This wear and tear leads to a decrease in that asset’s market value (or resale value). This is codified in Section 167 of the U.S. tax code. Given that this is the case, owners of “depreciable property” can take deductions to offset this loss in value. In other words, the tax code allows for a deduction to taxable income to compensate for the lower resale value of certain assets. However, once a taxpayer takes this deduction, the basis in the depreciable property decreases. All of this makes intuitive sense.  

Suppose you have a piece of depreciable property, such as an automobile. If a person is holding the automobile for investment or business purposes, then that person can take deductions for the loss in value to the automobile. This is common in car rental agencies, for instance. Again, the logic underlying this is very straightforward. On its resale, the owner of the automobile usually obtains only a fraction of its original cost. Accordingly, the owner also receives a reduction in his or her taxes, to offset this decline in resale value.  

Different Methods of Depreciating Property 

There are a number of different depreciation methods. Among all methods, some are more common than others. The four most common methods of depreciating property are the straight-line method, units of production, sum-of-years-digits, and the double-declining balance method. Of these, the straight-line method is the most common. Perhaps because it’s easy to grasp. In the straight-line method, an asset’s depreciation is over a consistent schedule for a fixed number of years. Let’s consider a quick example. If we depreciate a car with a value of $100,000 using the straight-line method over a period of five years, we have five annual deductions of $20,000 each. At the end of the five year period, the full cost of the car will be depreciated.  

There are other depreciation methods aside from these, but these are just the most common. Some methods are a bit more complicated than others, and some methods are only used for certain types of property. 

Difference Between Amortization Deductions and Depreciation Deductions 

Often, the phrase “amortization deductions” or “amortized deductions” will come up in this context. Amortization is nearly identical to depreciation, but with one subtle but important difference: amortization applies to intangible assets rather than tangible assets. Intangible assets include things such as patents and trademarks, franchise agreements, leaseholds, organizational costs and so forth. Amortization is a term which pertains to both accounting (the context here) and lending. However, the term is used in a separate way in each context.   

Depreciation May Lead to Recapture Taxation 

If you depreciate certain assets, the deductions may eventually be subject to “recapture” and subject to taxation following a sale. This is the case with real estate, for example. Suppose someone owns a rental property which they hold for investment. Rental real estate has a depreciation period of 27.5 years. This means that the full cost of the rental property is depreciated over this length of time. If the owner sells the rental property and then recognizes any gain over the adjusted basis, then this will trigger depreciation recapture taxation. The tax on depreciation recapture is a flat 25%.

Let’s consider an example. Suppose a taxpayer buys a rental property for $1 million, takes $200,000 of depreciation, and then sells the property for $1.2 million. The taxpayer will pay taxes on the capital gain, but also on the depreciation recapture. In this case, the taxpayer will pay 25% on the $200,000.  

Call Us to Learn More!

Here at Mackay, Caswell & Callahan, P.C., we work hard to become acquainted with all things tax related. Depreciation deductions can be a very useful way to lower your tax burden. And a lower tax burden means a lower chance of winding up with tax problems. Even if you take all possible deductions, however, it’s always possible to be saddled with back tax debt. If you do happen to run into tax debt issues, this is where we could be extremely helpful. Contact one of our top New York City tax attorneys today for additional information. 

Image credit: InvestmentZen 

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