1. Depreciation And Income Taxes
Chapter 6
Depreciation And Income Taxes

2. Preliminary Statement
The material presented in this chapter does not apply to the current (2001) U.S. Federal Corporate Income Tax Code relating to depreciation
As such, parts of this chapter could be modified by legislation enacted after publication of this text
You may use the current depreciation rules as they may pertain to the material in this chapter
Access the IRS web site {www,irs.gov} for IRS Publication 946 for the current rules and regulations

3. Learning Objectives Depreciation Terminology Depreciation Methods
Straight-Line Depreciation
Double Declining Balance Depreciation
Modified Accelerated Cost Recovery System (MACRS)
Determining the MACRS Recovery Period

4. Depreciation – Definition
Depreciation is the reduction of an asset’s value over time.
Brought on by:
Wear and tear, Use, Deterioration, Obsolescence
Deprecation represents a proper charge against future income produced by the asset in question.
TANGIBLE - can be seen or touched
Personal property - includes assets such as machinery, vehicles, equipment, furniture, etc…
Peal property - anything erected on, growing on, or attached to land (Since land does not have a determinable life itself, it is not depreciable)
INTANGIBLE - personal property, such as copyright, patent or franchise

5. Personal Property
Personal property is the income-producing, tangible possessions of a corporation used to conduct business.
Not to be confused with an individual’s personal property like clothes, furniture, etc.
Included are:
most manufacturing and service industry property vehicles,
manufacturing equipment, materials handling devices, computers, and networking equipment, telephone equipment office furniture, refining process equipment, and much more.

6. Real Property Real property includes real estate and all improvements
office buildings manufacturing structures, warehouses, apartments, and other structures.
Land itself is considered real property, but it is not depreciable because it has an infinite life – land can never be depreciated for tax purposes.

7. Importance of Depreciation
Federal tax law defines the concept of taxable income as:
Gross Income – Real Cash Expenses – interest – Depreciation amounts
Tax Due ={Taxable Income}(Tax Rate)
Federal Tax law permits the reduction of Gross Income by a category of elements termed “deductions”
Wages and salaries;
Cost of materials;
Utilities;
Interest Paid on debt;
State and local taxes paid;

8. Depreciable? Property is depreciable if it must:
be used in business or held to produce income
have a determinable useful life which is longer than one year
wear out, decay, get used up, become obsolete, or lose value from natural causes
not be inventory, stock in trade, or investment property

9. When Depreciation Starts And Stops
Depreciation starts when property is placed in service for use in business or for production of income
Property is considered in service when ready and available for specific use, even if not actually used yet
Depreciation stops when cost of placing it in service is removed or it is retired from service

10. Tax Equation General Federal Tax Equation
Taxable Income = Gross Income – {Real Expenses + Interest Paid + Depreciation+Depletion}
All of the above amounts EXCEPT depreciation amounts and depletion amounts are real cash flow to the firm
Depreciation and depletions amounts will lower the taxable income amount and hence the tax liability if claimed
For every $1 of eligible deductions the resultant tax savings is $0.30
$1 of additional deductions saves the firm $0.30

11. Types of Depreciation Book Depreciation Tax Depreciation
Value of the asset on the firm’s accounting records at any given point in time.
Used for internal managerial decision making.
Management is free to use any method they so choose to compute book depreciation amounts
Tax Depreciation
Used by a firm for state and federal income tax reporting
Follows strict rules and regulations.

12. Depreciation Terms The Basis (B) of an asset is:
Purchase cost plus,
Delivery costs plus,
Installation costs and,
Any other costs associated with installing and preparing the asset for use.
Book Value of an Asset (BVt)
The remaining, undepreciated capital investment on the firm’s books after the accumulated amounts of depreciation have been subtracted from the original cost basis.
BV’s are usually updated at the end of the firm’s accounting year.

13. Market Value Market Value (MVt)
Market value is the estimated amount realizable if the asset were sold on the open market.
Because of the structure of depreciation laws, the book value and market value may substantially differ.
For example, a commercial building tends to increase in market value, but the book value will decrease as depreciation charges are taken

14. Salvage Value
Salvage Value (SV) is the estimated trade-in or market value at the end of the asset's useful life
Expressed as an estimated dollar amount or as a percentage of the first cost
Salvage values are estimated “up-front” – at the time of the original purchase.
Generally speaking, one cannot depreciate an asset below its estimated salvage value.

15. Depreciation Models Basic (traditional) models are:
Straight-Line Method (SL),
Sum-of-the-Years Digits Method (SYD),
Declining Balance Method (DB).
Today, the MACRS Method (a form of declining balance-modified).

16. History Before 1981 – U.S. code recognized the classical methods.
1981 and after:
Classical methods were disallowed for federal tax purposes and replaced with a system termed ACRS – Accelerated Capital Recovery System
In 1986 ACRS was replaced with MACRS – Modified Accelerated Capital Recovery System.
Today--U.S. Federal Corporate Income Taxes must be computed using the MACRS system!
States generally permit all or part of the classical methods to be used for state corporate tax analysis

17. Recover Period
Recovery Period -- Number of years over which basis of property is recovered through accounting process.
Normally the useful life for classical methods
Property class for General Depreciation System (GDS) under MACRS
Class Life for Alternative Depreciation System (ADS)
If useful life not given
Use class life (Table 6-2) for SL and DB
Use Property Class (Table 6-2 or 6-4)
MACRS (General Depreciation System)

18. Depreciation Concepts
The following terms are used in the classical (historical) depreciation method equations:
N = depreciable life of the asset in years
B = cost basis, including allowable adjustments
d k = annual depreciation deduction in year k (1< k <N)
d k* = cummulative depreciation through year k
BV k = book value at the end of year k
BV N = book value at the end of the depreciable (useful) life
SV N = salvage value at the end of year N
R = the ratio of depreciation in any one year to the BV at the beginning of the year

19. Straight-Line: The Standard (SL)
Assumes the book value declines in a uniform manner down to a specified salvage value – S over n time periods
Compute the Basis minus the estimated salvage value and divide by n
d k = ( B - SVN ) / N
d k* = kdk for 1 < k < N
BVk = B - d k*

20. Declining Balance Method (DB)
DB is an accelerated depreciation method;
Provides greater depreciation amounts in the early time periods over the SL method
Requires assuming a DB rate (R)
dk for year k is found by multiplying the beginning of time period book value by the rate (R)
The maximum DB rate set by law is:
By law, the maximum rate for DB is specified to RMAX=2(1/N), or twice what the straight rate would be
If R = 1.5 (SL rate), it is termed the 150% DB rate

21. Declining Balance (DB) Method
Assumed depreciation is fixed percentage of BV at beginning of year
d 1 = B ( R )
d k = B ( 1 - R ) k - 1 ( R )
d k* = B [ 1 - (1 - R ) k ]
BV k = B ( 1 - R ) k
BV N = B ( 1 - R ) N
Because declining balance method never reaches BV = 0, it’s permissible to switch from this to straight-line method

22. Example
A computer was purchased for $20,000 and $2,000 was spent installing it. The computer has an estimated salvage value of $4,000 at the end of its class life. Compute the depreciation deduction in year 3 and the book value at the end of year 6 using:
a) straight-line method
b) 200% declining balance method

23. Solution Compute the Cost Basis (B); B =... Determine the Class Life
From Table 6-2, N = ...
Straight Line Method
d 3 = [( B - SVN ) / N ] = [(22, )/6)]=$3,000
BVk = B - d k* = BV6=
200% Declining Balance
R = 2/6 = 1/3 = 0.33; d k = B ( 1 - R ) k - 1 ( R )
d3 = B (1-R)k-1 (R) = 22,000(0.67)2 (0.33) =
d k* = B [ 1 - (1 - R ) k ]= d 6* = [ 1 - ( ) 6 ]=...
note: BV6 = B - d6* =

24. SL and DB Comparison
Straight Line 200% Declining Balance
EOY dk BVk dk BVk
, ,000
1 3, ,000 7, ,667
2 3, ,000 4, ,778
3 3, ,000 3,
4 3, ,000 2, ,345
5 3, , , ,897
6 3, , ,931

25. MACRS Method
MACRS was derived from the 1981 ACRS system and went into effect in 1986.
Defines statutory recovery (depreciation) percentages
Percentages were derived from the DB method with a switch to SL at the optimal time and incorporates the half-year convention.
The MACRS approach assumes a salvage value of “0” even though that might not be the case!
By current law – MACRS assumes all assets depreciated by this method will have a “0” salvage value at the end of the recovery life

26. The Half-Year Convention
During a tax year, assets are purchased and installed throughout the first year.
The half-year convention assumes that assets are placed in service or disposed of in midyear, regardless of when these events actually occur during the year.
Under past laws, the first year of depreciation had to be prorated by the number of months remaining in the tax year.
Under current federal tax law the first year is handled using the half-year convention.
If asset is disposed of before the full recovery period is used, only half of the normal depreciation deduction can be taken for that year

27. MACRS Recovery Periods
For Personal Property the following MACRS recovery periods apply:
3- years,5-years,7-years,10-years,15-years and, 20-years.
Property Classes
27.5-Year Property: (Real Property)
Residential rental property (homes and mobile homes).
39-Year Property (Real Property)
Nonresidential real property attached to the land, but NOT the land itself.

28. MACRS Personal Property Recovery Rates
Note, for each life
category there are N+1
percentage values where
N is the class life.

29. N+1 Rule
Note, for each life category there are N+1 percentage values where N is the class life
Why is this the case?
The actual recovery of a given class life assumes a half-year convention.
That is, it is assumed by law that an asset is placed in-service at the middle of the first year.
It does not matter when it is actually placed in-service;
So, only a ½ year of recovery is permitted in the first year.

30. Property Classes – Examples
3-Year Property:
Special manufacturing and handling devices, tractors and racehorses.
5-Year Property:
Computers and peripherals, Duplicating equipment, Automobiles, trucks, buses, Cargo containers, Some manufacturing equipment.
7-Year Property Class:
Office furniture, Some manufacturing equipment, Railroad cars, engines and tracks, Agricultural machinery, Petroleum equipment and natural gas equipment,
All property not in another class!
The 7-year class is the ‘default’ class!

31. Property Classes – continued
10-Year Class:
Water transportation equipment, Petroleum refining, Agricultural processing equipment, Durable goods manufacturing equipment, Ship building
15-Year Class:
Land improvements, Landscaping, Pipelines,
Nuclear power production equipment, Telephone distribution and switching equipment.
20-Year Class:
Municipal sewers, (developers), Farm buildings, Telephone switching equipment, Power production equipment, Water utilities equipment.

32. The Alternate Depreciation System
The IRS offers what is termed the Alternate Depreciation System – ADS.
It is a modified form of the MACRS system.
Applies a straight-line approach with the half-year convention.
Generally used by small or growing firms that do not have sufficient taxable income now and in the immediate future.
Some firms may not be generating sufficient profits to take advantage of the more accelerated depreciation rates that the MACRS-GDS provides.
Thus, if GDS is elected, the firm may be losing deductions in the early years.
ADS provides some relief for firms in this situation.

33. ADS or GDS For both the ADS and the GDS:
For a given tax year the firm elects either the:
ADS system for all assets placed in service for the current tax year or,
The GDS (accelerated method) for all assets placed in service for the current tax year.
The firm cannot mix ADS with GDS within the tax year! (It must be one or the other.)
In engineering economy analysis of industrial projects:
Most analysis will be accomplished using the GDS – accelerated depreciation rates.

34. ADS: Overview: 5-Year Example
ADS applies a form of the straight-line method with the half-year convention.
Assume 5-Year Property Class;
N = 5, R = 0.20 per year except in the first year and in the last year (N=6)
Year 1: R1 = ½(0.20) = 0.10 or 10% of B
Years 2-5 = 0.20 or 20% of B;
Remaining amount – 10% flows over to the last year, k= 6.

35. Information Needed To Calculate MARCS Depreciation
1. The cost basis
2. The date the property was placed in service
3. The property class and recovery period
4. The MACRS depreciation used (GDS or ADS)
5. The time convention that applies (half year)

36. Book Value Plot for Classical Methods
For SL, DB, and MACRS we have:
SL book values decline in a linear fashion down to a specified salvage value.
The DB method allows the book value to accelerate faster since the DB plot of book value is below the SL book values
MACRS also permits accelerated book values, but is not as good as the pure DB method permits.

37. Accelerating Depreciation
The SL methods writes off the asset in equal amounts over the recovery period.
The DB method permits greater depreciation amounts in the early years, and hence reduces the book value faster than the SL method.
Likewise for the MACRS method!
More depreciation in the early years means more tax savings sooner.
Larger depreciation amounts early on result in increased PW of future tax savings to the firm.

38. Example
The La Salle Bus Company has decided to purchase a new bus for $85,000, with a trade-in of their old bus. The old bus has a trade-in value of $10,000. The new bus will be kept for 10 years before being sold. Its estimated salvage value at that time is expected to be $5,000.
Compute the following quantities using (a) the straight-line method, (b) the 200% declining balance method, and (c) the MACRS method.
1. depreciation deduction in the first year and the fourth year
2. cumulative depreciation through year four
3. book value at the end of the fourth year

39. Solution First, we must calculate the cost basis.
Next, we must determine the depreciable life.
From Table 6-2, the class life = 9 years and the GDS recovery period = 5 years for buses. SL
dk =( )/9 = $10,000;
1. d1 = d 4 = $… ;
2. d4* = 4 ($10,000) = $40,000;
3. BV4 = B - d4* = $95,000 - $40,000 = $55,000

40. 200% Declining Balance Method
R=2/9; d 1 = B ( R )= 95000(2/9)=...
1. d k =B(1 - R) k - 1 ( R )= d 4 = 95000(1 - (2/9) )3 (2/9)=...
2. d k* = B [ 1 - (1 - R ) k ]= ...
3. BV k = B ( 1 - R ) k
MACRS Method (Note: A class life = 9 years corresponds to an MACRS recovery period = 5 years
1. d1 = (0.2) ($95,000) = $19,000
d4 = (0.1152) ($95,000) = $10,944
2. d4* = $95,000 ( ) = $
3. BV4 = $95,000 - $78,584 = $
What happens if the asset is sold before the end of the recovery period?-- can only take half of the normal MACRS deduction
For example, if the bus is sold in year 4, d4 = $95,000 (0.1152) (0.5) = $5,472