Different depreciation methods vary in the amounts booked each year. Straight-line depreciation is the simplest available depreciation method. The annual depreciation expense is equal to the net original cost of an asset divided by the asset’s useful lifetime. There are guidelines for depreciation lifetimes depending on the type of asset. The lifetimes can range from three to twenty or more years. Alternative methods feature accelerated depreciation – assets are expensed at a faster rate than that used for straight-line depreciation. Accelerated depreciation allows companies to reduce net income and income tax expense in the early years of an asset’s depreciable lifetime. This effect reverses in later years.
Buildings normally last a long time. A recovery period is the amount of time in which you depreciate an asset, so buildings typically have long recovery periods. You reflect the choice of recovery period under generally accepted accounting principles, or GAAP, in your financial reporting. The Internal Revenue Service has its own set of depreciation rules and you must use their recovery periods when figuring taxable income.
GAAP Recovery Period
Under GAAP, you estimate the useful life of a building and use this as your recovery period. You can base your estimate on your previous experience or by estimates provided by qualified persons, such as engineers and architects. If you build or buy a brand new building, you might expect it provides useful service for many decades.
If you buy an old building, you need to factor in its age and condition to make a reasonable estimate of its recovery period. You should also factor in frequency of use, repair policies and amount of wear and tear - a building on the North Slope of Alaska might not last as long as the same building in Houston. Under GAAP, you must estimate the salvage value of a building and cannot depreciate below this value.
Other Recovery Periods
Commercial buildings are considered nonresidential real property. For buildings placed in service after 1986, you use the Modified Accelerated Cost Recovery System, or MACRS, which specifies recovery periods for depreciable assets. MACRS comes in two flavors: The General Depreciation System, or GDS, and the Alternative Depreciation System, or ADS. GDS is the default system, and it specifies a recovery period of 39 years for nonresidential real property. If you are a tax-exempt organization, use the property less than 50% for your business, are a farmer or you simply elect to, you can use the slightly less aggressive ADS, which has a building recovery period of 40 years.
For residential rental property, the GDS recovery period is 27.5 years. The ADS recovery period recently fell from 30 to 40 years. The recovery period for vehicles used in business is five years.
Significance of GAAP vs MACRS
The GAAP recovery period and depreciation method helps to determine the book value of a building, which appears on the company balance sheet. The book value is its purchase price/construction cost, plus improvements and minus depreciation. The longer you set the recovery period, the slower the decline in book value. This can affect financial ratios, such as return on assets. Depreciation is only significant for tax accounting. The MACRS recovery period and depreciation method determines a company’s depreciation expense in a tax year. Companies may keep two sets of accounting books. Businesses normally disclose depreciation differences between the books in a footnote to their financial statements.
If you put a building into service between 1981 and 1986, you use a different system to estimate a building’s recovery period for tax purposes. The system was quite flexible and allowed recovery periods from 15 years to 45 years. For properties you put into service before 1981, you were to follow guidelines for tax-related recovery periods that closely resemble GAAP guidelines.
Depreciation of Leasehold Improvements
Lessees often make improvements to leased property. For example, a clothing merchant may lease an empty storefront and add fixtures, storage rooms, bathroom facilities or a security system. This merchant can depreciate the cost of leasehold improvements over a number of years that depends on the exact nature of the improvement.
Qualified Improvement Property (QIP)
A lessee can depreciate leasehold improvements made to qualified improvement property, which is property that meets certain Internal Revenue Service standards. To be qualified, the lessee or lessor must make the leasehold improvement according to the terms of the lease, in a part of the building exclusively occupied by the lessee. Some leasehold improvement are nonqualifed. Examples of nonqualified improvements include enlarging the building, installing or improving escalators, and improving common areas or the internal framework of the building.
Leasehold improvements must use straight-line depreciation, meaning identical deductions each year over the asset’s lifetime. Under ADS and GDS, nonqualified leaseholds have a recovery period of 39 years, but qualified leasehold improvements were meant to have a recovery period over a shorter lifetime of 15 years. However, an error in the legislation make the QIP recovery period 39 years. As yet, this error has not been corrected.
Qualifying for a Bonus
Section 179 property (certain non-real-estate commercial assets such as machinery and equipment) can be expensed in the year it goes into service instead of being depreciated over a recovery period. The current limit on the immediate deduction of Section 179 property is $1 million, but the deduction phases out if you purchase more than $2.5 million in Section 179 property during the year. As of 2018, QIP can also be classified as Section 179 property.
In addition, qualified personal property put into service after Sept 27, 2017, can get 100% bonus depreciation in the first year. This bonus applies each year until 2023, after which the bonus depreciation rate decreases. Once you take your Section 179 allowance, you can apply a bonus depreciation in the year of the qualified leasehold improvement. You depreciate the remaining unrecovered costs over the regular recovery period.