The Rules of Depreciation
Through tax legislation, assets are classified according to nine categories that determine the allowable rate of depreciation write-off. Each class is referred to as a “MACRS” category; MACRS stands for modified accelerated cost recovery system. Some references are also made to ADR, which stands for asset depreciation range, or the expected physical life of the asset or class of assets. Most assets can be written off more rapidly than the midpoint of their ADR. For example, an asset may have a midpoint of its ADR of four years, which means the middle of its expected useful life is four years; this asset might be written off over three years. Table 12-11 shows the various categories for depreciation, linking the depreciation write-off period to the midpoint of the ADR.
It is not necessary that you become an expert in determining the category of an asset. In problems at the end of this material you will be given enough information to easily make a determination.
Each of the nine categories in Table 12-11 has its own rate of depreciation that can be applied to the purchase price of the asset. We will direct our attention to the first six categories in the table, which apply to assets normally used in business transactions. The last three categories relate to real estate investments and, for purposes of simplicity, will not be covered.
Table 12-11 Categories for depreciation write-off
|3-year MACRS||All property with ADR midpoints of four years or less. Autos and light trucks are excluded from this category.|
|5-year MACRS||Property with ADR midpoints of more than 4, but less than 10 years. Key assets in this category include automobiles, light trucks, and technological equipment such as computers and research-related properties.|
|7-year MACRS||Property with ADR midpoints of 10 years or more, but less than 16 years. Most types of manufacturing equipment would fall into this category, as would office furniture and fixtures.|
|10-year MACRS||Property with ADR midpoints of 16 years or more, but less than 20 years. Petroleum refining products, railroad tank cars, and manufactured homes fall into this group.|
|15-year MACRS||Property with ADR midpoints of 20 years or more, but less than 25 years. Land improvement, pipeline distribution, telephone distribution, and sewage treatment plants all belong in this category.|
|20-year MACRS||Property with ADR midpoints of 25 years or more (with the exception of real estate, which is treated separately). Key investments in this category include electric and gas utility property and sewer pipes.|
|27.5-year MACRS||Residential rental property if 80% or more of the gross rental income is from nontransient dwelling units (e.g., an apartment building); low-income housing.|
|31.5-year MACRS||Nonresidential real property that has no ADR class life or whose class life is 27.5 years or more.|
|39-year MACRS||Nonresidential real property placed in service after May 12, 1993.|
The rates of depreciation that apply to the first six classes in Table 12-11 are shown in Table 12-12.3 The rates shown in Table 12-12 are developed with the use of the half-year convention, which treats all property as if it were put in service in midyear. The half-year convention is also extended to the sale or retirement of an asset. Thus for three-year MACRS depreciation, there are four years of depreciation to be taken, as demonstrated below:
|Year 1||½ year|
|Year 2||1 year|
|Year 3||1 year|
|Year 4||½ year|
|3-year MACRS depreciation|
For five-year depreciation, there are six years to be taken, and so on.
Table 12-12 Depreciation percentages (expressed in decimals)
Let’s return to Table 12-12 and assume you purchase a $50,000 asset that falls in the five-year MACRS category. How much would your depreciation be for the next six years? (Don’t forget that we get an extra year because of the half-year convention.) The depreciation schedule is shown in Table 12-13.
Table 12-13 Depreciation schedule
The Tax Rate
In analyzing investment decisions, a corporate tax rate must be considered. As mentioned in Chapter 2, the rate has been changed four times since 1980, and it is almost certain to be changed again in the future. Although the maximum quoted federal corporate tax rate is now in the mid–30 percent range, very few pay this rate. Smaller corporations and those with big tax breaks for research and development, new asset purchases, or natural resource development may only pay taxes at a 15 to 20 percent rate. Larger corporations with foreign tax obligations and special state levies may pay effective total taxes of 40 percent or more. In the following examples, we shall use a rate of 35 percent, but remember, the rate varies from situation to situation and from time period to time period. In the problems at the back of the chapter, you will be given a variety of tax rates with which to work.