Back to Basics Part XVII – Form 4562 – Depreciation and Amortization

Originally published in the Cedar Street Times

June 26, 2015

If you want to take a relatively simple concept and complicate it to the nth degree, then you will fall in love with depreciation expense!  I am sure there have been numerous doctoral candidates in the accounting field that have written their dissertations on the topic of depreciation.  There are so many angles – matching the expense of an asset with the revenues it generates, shifting economic policies, grandfathering of legacy rules, and of course politics and lobbyists.  Today we will be talking about Form 4562 – Depreciation and Amortization.  If you would like to catch up on our Back to Basics series on personal tax returns, prior articles are republished on my website at www.tlongcpa.com/blog .

At its core, the concept of depreciation expense is rooted in what accountants call the “matching principle.”  You are trying to spread out the cost of purchasing an asset for your business or investment activity over the years that it is useful to you – thus allocating the expense to the periods of revenue that result from the asset.  Take a pencil for example.  You purchase the pencil at the beginning of the year.  You use it to write notes, draft reports, and fill out forms, which lead to revenue throughout the year.  By the end of the year you are left with a short stub, riddled with bite marks and a half-used blue pencil top eraser with a split down the side…so you throw it away. On your tax returns you have a $50,000 of revenue, offset by a $0.25 deduction for the pencil that helped generate the revenue.  Clearly, the revenue and the expense were matched in the same period.

But what about the stapler that you also bought at the same time as the pencil?  You bought a quality, metal stapler for $25.  It could be sitting on your desk until you retire, and then get passed on to your successor!  Let us assume it helps you earn revenue for 25 years before becoming the victim of a careless office prank.  The matching principle would say you take the $25 and spread it out over the 25 years of its useful life, taking a $1 of expense each year against the revenue it helped you earn all those years.  You would of course have to track the stapler on a schedule and each year update it for the depreciation expense taken.  It would be helpful to have a column for the accumulated total of depreciation you had taken over the years so you know what is left to deduct as well.

That is depreciation expense in its simplest form.  Unfortunately, the tax code is anything but simple – sometimes for good reasons, and sometimes for not so good reasons.  A full explanation of depreciation rules would require thousands of pages of text.  Here are some of the key concepts to help you swim with depreciation.  It is important to note that depreciation is not a choice.  There are choices within the depreciation laws, but you cannot just say – I do not want to participate.

Depreciation vs. Amortization – essentially a matter of semantics. Depreciation is the word used in association with tangible assets purchased; amortization is the word used in association with intangible assets purchased, such as goodwill, patents, and copyrights.

Depreciation Policy – it would be impractical to track every asset you buy that has a useful life of more than a year (like the stapler!), so depreciation policies are developed in accordance with limits established by law.  For instance, everything over $500 will be depreciated, and everything below that will just be expensed in the year it is purchased.

Asset Classes – the IRS has pre-determined the periods and methodology for depreciating the vast majority of assets.  The Modified Accelerated Cost Recovery System (MACRS) is the system used for depreciation today.  Inside that there is the general depreciation system and the alternative depreciation system (ADS) (ADS is mainly used for assets held outside the U.S.).  Inside the more common general depreciation system there are 3-year, 5-year, 7-year, 10-year, 15-year, etc. on up to 50-year asset classes.  For instance, off-the-shelf computer software is 3-year property; machinery, equipment, and computers in a business are 5-year property; and land improvements are 15-year property.

So you do not just pick the expected useful life in your opinion – you use what the IRS says, instead.  Of course there are always strange nuances – such as furniture in a business is 7-year property but furniture in a residential rental is 5-year property.  Or the fact that the residential rental house you own is 27.5-year property, but an entire “motorsports entertainment complex” is only 7-year property (think NASCAR lobbyists).  These classes are generally “accelerated” as well, meaning you do not simply divide the cost by the number of years and depreciate it ratably.  That would be “straight-line depreciation.”  Instead there are methods such as 200% Declining Balance and 150% Declining Balance that front-load the depreciation expense in the early years, resulting in less in the later year.

There are also “conventions” depending on the asset class and date it is placed in service during the year when you first acquire it.  These include “half-year,” mid-quarter,” and “mid-month,” and determine how you calculate the depreciation in the first year.  To make matters more complicated, the tax laws have changed over the years, but the system that was in place when you placed the asset in service governs it for life.  MACRS was established in 1986.  Prior to that, there were several other systems with their own sets of rules: the Accelerated Cost Recovery System (ACRS) was used from 1981-1985, and prior to that, the Asset Depreciation Range (ADR) system was used.  It is still possible to have assets under ADR, ACRS, and MACRS!  To say that software is necessary is an understatement.  It certainly works wonders with the calculations, but you still have to understand the laws and options to make the right selections and decisions.

Section 179 Deduction – from year-to-year the political and economic environments dictate an incredibly powerful deduction under IRS Code Section 179.  This code section is kind of like an override that allows you to elect to expense assets in their entirety in the year purchased rather than spreading the deduction out over a period of years.  The code section was created in 1958 when it had a $2,000 cap.  The amounts were slowly raised up to $25,000 by 2003.  Since then, each year Congress has made huge overrides to the codified $25,000 amount jumping it to $100,000, $125,000, $250,000, and even $500,000 where it has been for the last five years, but it generally defaults back to the $25,000 figure where it currently sits for 2015, unless Congress “saves the day” again.  Many business owners have come to rely on this for large purchases, but it is good to remember, it may not be there.  Certain assets do not get 179 treatment or there are modified rules.  Vehicles for instance are not eligible unless it is a vehicle with a gross weight rating of over 6,000 pounds.  Even then, the depreciation amount has been capped at $25,000 in recent years on those particular vehicles.  For assets you want to elect to claim the 179 treatment, you still must go through the formal process of setting them up on a depreciation schedule and reporting them on the Form 4562.

Bonus Depreciation/Special Depreciation – these are additional concepts that Congress has created over the years allowing more depreciation in certain circumstances.  One of the concepts with special depreciation has been that the assets must be brand new (not purchased in used condition).  This was certainly a policy implemented to try to stir the economy.

Other Rules – there are a host of other rules, such as how to handle assets that you exchange for other ones (like trading in a vehicle), what do you do if you convert the asset to personal use, or use assets for both business and personal use, what do you do when you sell assets, etc.  And there are lots of very pointed rules that clearly address certain industry desires such as “qualified second generation biofuel plant property,” which apparently was important enough to the masses to warrant half a column among the sea of information that could have been presented in the condensed 22 pages of instructions to the Form 4562!

The Form 4562 itself is two pages long.  The first section deals with reporting any assets for which you are electing to take a Section 179 deduction.  The next section deals with Special Depreciation.  The third section deals with reporting assets under the regular MACRS depreciation asset classes, but you only have to list the assets on the form during the first-year they are placed in service – not every year.  Your separately maintained depreciation schedules will track them for all years.  Depreciation schedules need not be submitted to the IRS with your returns, but should be maintained for reference and in the event of an audit.  The fourth section is a summary.  The majority of the second page deals with automobiles and listed property, which are required to be reported each year, since they have special limiting rules.  Listed property includes certain types of property that often have mixed personal and business use, so the IRS wants to monitor these more closely. The final section is for amortizable assets.  As with depreciable assets, you only have to list amortizable assets in the first year they are placed in service.

Keep in mind that besides the regular depreciation schedules, you also typically have to maintain separate state depreciation schedules, which can have their own rules.  California, for instance, does not conform to Section 179 deductions among many other things.  In addition, you should track Alternative Minimum Tax (AMT) versions of the federal and state schedules as they can differ as well, should you be impacted by AMT.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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