Basics of Depreciation

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The basicsof depreciationbyJohnL.BallExtensionMarineEconomistOregonStateUniversity

ThisbulletinwillhelpyouunderstandvariousInternalRevenueServiceregulationsandpublicationsastheyapplytoyourmarinebusiness.It isnotasubstituteforIRSregulationsandpublications,orforexpertcounselyoumayobtainfromtheIRSorprofessionaltaxpractitioners.

Youmaydeducteachyear,asdepreciation,areasonableallowancefortheexhaustion,wearandtear,andobsolescenceofdepreciablepropertyusedinyourtradeorbusinessorheldfortheproductionofincome.Whatfollowsisahighlycondensedexplanationofdepreciation,fortaxpurposes.Formoredetailedinformationondepreciationfortaxpurposes,consultIRSPublications595and534.Stepsindeterminingdepreciation1.eterminewhetheraparticularcostitemrepresentsacapitalexpenditureoradeductibleexpense.See"Glossaryofterms,"page3.)2.eterminethe"basis"and"adjustedbasis"fordepreciationofcapitalexpenditures.

3.etermineausefullifefortheproperty.4.stimateasalvagevalueattheendofitsusefullifeinthebusiness.5.ecidewhetherthepropertyqualifiesfor"Additionalfirst-yeardepreciation."6.fterdecidingwhetherornottotaketheadditionalfirst-yeardepreciation,selectthemostsuitableallowedmethodofdepreciationforproperty,andsetupadepreciationschedule

basedupontheadjustedbasis.

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iOOpQQ 46Capitalexpendituresversusrepairs

Capitalexpendituresepresentinvestmentsofcapitaleithertoacquirepropertywithausefullifeofmorethanoneyearortomakepermanentimprovementsorbettermentthatincreasethevalueofthepropertyorappreciablyprolongitslife.Capitalexpendituresmustbedepreciated.Repairsmerelymaintainthepropertyinanordinarilyefficientoperatingconditionoverit sestimatedusefullife,forthepurposesforwhichitwasacquired.Repairsaredeductibleintheyeartheyoccur.

Anothertitlein theseries

Marinebusiness management

ChoosingocapitalizeIncertaincircumstances,theFederalincometaxlawspermityoutochooseeithertoclaimacurrentdeductionortocapitalizespecifiedtypesofexpenditureThusyoumaychoosetotreata scapitalexpenditurescertainitemsthatyouwouldotherwisedeductcurrently,oryomaychoosetodeductcurrentlycertainitemsyouwouldotherwisetreata s capitalexpenditures.Yo umaycapitalizecarryingcharges,interest,andcertain

taxesthatareotherwisedeductiblewithrespecttocertainpersonalproperty(aboatengine,electronicgear,etc.),ifyousochoose.Basisofbusinessassets

"Basis"ofpropertyis usedindeterminingthedeductionfordepreciation.Thecostorpurchasepriceofthepropertygenerallyistheoriginalbasis.However,ifthepropertywasacquiredbygiftorinheritance,orinsomeothermanner,anoriginal"basisotherthancost" mustbeused.Whenthecostorpurchasepriceofapieceofpropertyis usedasthebasisfordepreciation,thistotalshouldalsoinclude"settlementfees"salescommissions,legalandfilingfees,etc.).Thebasisshouldbethetotalcosttoyouincludingcash,debt obligations,orotheproperty.Therearecaseswhereabasisotherthancostmustbeused.Herefairmarketvalueplaysapart.TheIRSdefines"fairmarketvalue"as"thepriceatwhichthepropertywouldchangehandsbetweenawillingbuyerandawillingseller,neitherbeingunderanycompulsiontobuyorsellandbothhavingreasonableknowledgeof allrelevantfacts."

OregonStateUniversityExtensionMarineAdvisoryProgramALandGrant/eaGrantCooperatiSG36 November1976

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AdjustedbasisAdjustedbasisdependsuponadditionsandeductions:Additions.Thebasisofanypropertyisincreasedbyallitemsorexpendituresthatareproperlychargeabletocapitalaccountexceptasnotedlater).Includedinthiscategoryisthecostofanyimprovementsmadetopropertythathaveausefullifeofmorethanoneyear.Thecostsofpurchasecommissions,legal

feessuchas thecost ofdefendingandperfecting titlesincludingtitleinsurance),andrecordingfees,arealsoaddedtothebasisofproperty.

Reductions.Youmustdecreasethebasisofyourpropertybyanyitemsthatrepresentareturnof capital.Theseincludesuchthingsasadditionalfirst-yeardepreciation,ecognizedlossesoninvoluntaryconversions,andcasualtylosses;anddeductionspreviouslyallowedorallowable)oramortization,depreciation,obsolescence,anddepletion.Yo udonotreducebasisbecauseoftheinvestmentcredit.Depreciationestrictions

Thekindofpropertyonwhichyouordinarilymayclaimthedepreciationdeductionispropertywithausefullifeof morethanoneyear.Itmustalsobefor business.Youmaynotdeductdepreciationonpropertyyouandyourfamilyuseasaresidence,yourautomobileusedsolelyforpleasureorforcommuting,etc.Youmaydeductdepreciationontangiblepropertysee"Glossary").Buildingsmaybedepreciated;landmaynot.Ifintangiblepropertysee"Glossary")usedinyourbusinesshasalimitedperiodof usefulness,itmaybedepreciated.Yourunsupportedopinionisnotsufficienttoestablishthatfact,butyourexperienceandotherfactorsmaybeusedinthedetermination.

AmountofdepreciationdeductionYoushouldtaketheproperdepreciationineachtaxyear.Ifyoufailedtodeductallowabledepreciationinpastyears,you maynotdeducttheunclaimeddepreciationinthecurrentor

alatertaxyear.If youacquireordisposeofpropertyduringtheyear,anddonotuseanaveragingconvention,regulardepreciationisallowableforonlypartoftheyear.Depreciationbeginswhenthepropertyis placedinserviceandendswhenthepropertyisretiredfromservice.Usefulife

Thefirststepincomputingdepreciationistodeterminetheestimatedusefullifeoftheproperty.Noaverageusefullifeisapplicablein allbusinesses.Theusefullifeofanypropertydependsuponsuchthingsasthefrequencywithwhichyouuseit;itsagewhenyouacquiredit;yourpolicyastorepairs,renewals,andreplacements;heclimateinwhichitis used;andthenormalprogressofthearts,economicchanges,nventions,andotherdevelopmentswithintheindustryandyourtradeorbusiness.

Youshoulddeterminetheusefullifeofthedepreciablepropertyonthebasisofyourparticularoperatingconditionsandexperience.Ifyourexperienceis inadequate,youmayusethegeneralexperiencein theindustryuntilyourownexperienceformsanadequatebasisformakingthedetermination.Salvagevalue

Salvagevalueistheamount(determinedatthetimeofacquisition)thatyouestimate will berealizedonsaleor otherdispositionof thepropertywhenitis nolongerusefulin yourbusinessorin theproductionofyourincomeandis to beretiredfromservice.

Additionalirst-yeardepreciationYou maychoosetodeduct20%fthecostofqualifyingpropertysubject

toadollarlimitationdiscussedlater)sadditionalfirst-yeardepreciation,inadditiontoyourregulardepreciation.Yo udonotusesalvageincomputingthisdeduction.Youmaytakethisdeductiononlyinthefirstyearforwhichdepreciationdeductionisallowableontheproperty.Thisisordinarilytheyearinwhichyouacquiretheproperty.Neworusedtangiblepersonalpropertyhavingausefullifeofatleasts ix yearsdeterminedatdateofacquisition)qualifiesforadditionalfirst-yeardepreciation.Buildings,heirstructuralcomponents,land,andintangiblepersonalpropertysucha s patents,donotqualifyforthededuction.Thecostofpropertyonwhichyoumaytakethisadditionalallowanceis limitedto$10,000onaseparatereturnand$20,000onajointreturn.Theadditionalfirst-yeardepreciationdeductionisdeterminedwithoutadjustmentto basisforsalvagevalueandisallowedin full,eventhoughyouacquirethepropertyduringtheyear.Yo uthencomputeordinarydepreciationonthecostorotherbasisoftheproperty,lesstheadditionalfirst-yeardepreciationdeductionandsalvagevalue.Methodsofcomputingdepreciation

Thethreemethodsmostgenerallyusedincomputingdepreciationare:1.traightine2.ecliningbalance3.umoftheyears-digitsThereareotheracceptablemethodsthat youcanusea slongastherateofdepreciationfordifferenttypesofpropertystayswithinthelimitsestablishedintheIRSCode.fyouplantouseanymethodotherthansimplestraight-linedepreciation,itis recommendedthatyougetcopiesoftheIRSpublicationsandcontactanIRSofficeforallowablemethodsandrates.

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Straight-linemethod.Thecostorotherbasisoftheproperty,lessit s salvagevalue,is deductedinequalannualamountsovertheperiodofitsestimatedusefullife.Todeterminethedepreciationforeachyear,dividetheadjustedbasisoftheproperty,lesssalvagevalue,bytheremainingusefullife.Youmust usethismethodforanydepreciablepropertyforwhichyouhavenotadopteda differentacceptablemethod.

Declining-balancemethod.Thedepreciationyoutakeeachyearis subtractedfromthecostorotherbasisof thepropertybeforecomputingthenextyear'sdepreciation.Thesamedepreciationrateappliestoasmallerordecliningbalanceeachyear.Thus,alargerdepreciationdeductionistakenforthefirstyearandagraduallysmallerdeductionin succeedingyears.Withinlimits,thedepreciationrateusedisgreaterthantheratethatwouldbeusedunderthestraight-linemethod.Undersomecircumstances,you mayusearatetwiceasgreataswouldbeproperunderthestraight-linemethod.Underothercircumstances,youarelimitedtoarateIJ aorPAtimesasgreata stherateyouwoulduseunderthestraight-linemethod.Youdonotdeductsalvagevaluefromthecostorotherbasisofyourpropertyin determiningtheannualdepreciationallowanceunderthedeclining-balance method.However,youmustnotdepreciateyourpropertybelowit sreasonablesalvagevalue.Twicethestraight-lineratemaybeusedtocomputedepreciationunderthismethod,ontangiblepersonalpropertyhavingausefullifeofthreeyearsormorethatisacquiredneworis constructedorerectedbyyouafterDecember31,953.

Example.Assumeyoupurchasednewelectronicgearin Januaryofthisyear,for$2,000,andit sestimatedlifeis tenyears.Underthestraight-linemethodofcomputingdepreciation,therateis 10%.Sincethiselectronicgearmeetsalltheconditionsstatedabove,y6u maydepreciateitunderthedeclining-balance methodataratetwicethestraight-linerate,or20%.Yourdepreciation allowanceonthisequipmentforthisyearis $400,whichis 20%of$2,000.Yourdepreciationallowancethefollowing yearis $320, or20%of$1,600($2,000minus$400).

Sumoftheyears-digitsmethod.Thismethodmaybeusedonlyonpropertythatmeetstherequirementsfortwicethestraight-linemethodunderdeclining-balancemethod.Underthismethod,youapplyadifferentfractioneachyeartothecost orother basisof eachsingle-assetaccountreducedbyestimatedsalvagevalue.Thedenominatorof thefraction,whichremainsconstant,is thesumofthedigitsrepresentingtheyearsofestimateduseful lifeoftheproperty.Forexample,iftheestimatedusefullifeisfiveyears,thedenominatoris15,thatis ,thesumof1+2+3+4+5.Thenumeratorofthefractionchangeseachyeartorepresenttheyearsofusefulliferemainingatthebeginningoftheyearforwhichthecomputationis made.Forthefirstyearofafive-yearestimatedusefullife,thenumeratorwouldbe5,forthesecondyear4,etc.Thus,forpropertywithanestimatedusefullifeoffiveyears,thefractionyouapplytothecost orotherbasis, minussalvagevalue,to computedepreciation forthefirstyear,is5/15.Thefractionsforthesecond,third,fourth,andfifthyearsare4/15,3/15,2/15,and1/15,respectively.

ReferencematerialsIRSPublication595,TaxGuideforCommercialFishermen.

IRSPublication534,TaxInformationoDepreciation.GlossaryoftermsDepreciationAreasonablellowance,whichmaybedeductedeachyear,fortheexhaustion,wearandtear,andobsolescenceofdepreciablepropertyusedinyourtradeorbusinessor heldfortheproductionof income.DepreciablepropertyPropertywithausefullifeofmorethanoneyearthatisusedin yourtradeorbusinessorheldfortheproductionof income.CapitalexpendituresExpendituresorthepurchase,construction,reconstruction,shipment,nstallation,andthelike,forpiecesofdepreciablepropertypropertywithausefullife

ofgreaterthanoneyear).DeductibleexpensesExpensesontemwithalifelessthanoneyearorwhichareconsideredconsumed

withinhatyear.Realproperty,personalproperty,tangiblepersonalproperty,ntangiblepersonalpropertyRealpropertyreferstoland,buildings,andothersuchimprovements.Personalpropertyincludestangibleitemstrucks,fishinboats,nets,andthelike)ndintangibleitemsfranchises,licenses,goodwill,etc.).

UsefullifeThelengthof timethatapieceofpropertyisexpectedtobeusedin yourtradeor businessorheldfortheproductionof income.SalvagevalueTheamount(determinedatthetimeofacquisition)hat youestimatewill berealizedonthesaleorotherdispositionofapieceofpropertywhenithasreachedtheendofits"useful life"baseduponitsdepreciationschedule).Additionalirst-yeardepreciationAdeductionof 20%ofthecostofusedor newtangiblepersonalpropertywith ausefullifeofsixyearsor morethat maybetakenwithcertaindollalimitations)nadditiontotheregulardepreciation.

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OREGON TATEUNIVERSITY EXTENSIONaSERVICE

ExtensionService,OregonStateUniversity,Corvallis,HenryA .Wadsworth,director.Thispublicationwas producedanddis-tributedinfurtheranceoftheActsof CongressofMay 8an d June30 ,1914.ExtensionworkisacooperativeprogramofOregonStateUniversity,theU.S.DepartmentofA griculture, an dOregoncounties.Extension'sMarineAdvisoryProgramissupportedinpartbytheSeaGrantProgram,NationalOceanic an dAtmos-phericAdministration,U.S.DepartmentofCommerce.Extensioninvitesparticipationinitsactivitiesand offersthemequallytoal lpeople,withoutdiscrimination.

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