Tax Depreciation
Lecture No. 34
Chapter 9
Contemporary Engineering Economics
Copyright © 2006
Contemporary Engineering Economics, 4th
edition, © 2007
Brief History on Tax Depreciation
Purpose: Used to report income taxes for the IRS
Assets placed in service prior to 1981
 Use the book depreciation methods (SL, DB, SOYD)
Assets placed in service from 1981 to 1986
 Use the ACRS (Accelerated Cost Recovery System) Table
Assets placed in service after 1986

Use the MACRS (Modified ACRS) Table
Contemporary Engineering Economics, 4th
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Modified Accelerated Cost Recovery Systems
(MACRS)

Personal Property
 Depreciation method based on DB method
switching to SL
 Half-year convention
 Zero salvage value

Real Property
 SL Method
 Mid-month convention
 Zero salvage value
Contemporary Engineering Economics, 4th
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MACRS Property Classifications (IRS Publication 534)
Recovery Period
ADR Midpoint Class
3-year
Applicable Property
Special tools for manufacture of plastic
ADR  4 products, fabricated metal products, and
motor vehicles.
5-year
7-year
10-year
15-year
4  ADR  10
10  ADR  16
16  ADR  20
20  ADR  25
20-year
25  ADR
Automobiles, light trucks, high-tech
equipment, equipment used for R&D,
computerized telephone switching systems
Manufacturing equipment, office furniture,
fixtures
Vessels, barges, tugs, railroad cars
Waste-water plants, telephone- distribution
plants, or similar utility property.
Municipal sewers, electrical power plant.
27.5-year
Residential rental property
39-year
Nonresidential real property including
elevators and escalators
ADR: Asset Depreciation Range
Contemporary Engineering Economics, 4th
edition, © 2007
MACRS Depreciation Schedules for Personal
Property with Half-Year Convention
Contemporary Engineering Economics, 4th
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MACRS Rate Calculation
Asset cost = $10,000
Property class = 5-year MACRS
DB method = Half-year convention, zero salvage value,
200% DB switching to SL
20%
32% 19.20% 11.52% 11.52% 5.76%
$2000 $3200 $1920 $1152 $1152
Full
Full
Full
1
2
3
4
Half-year Convention
$576
Full
5
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edition, © 2007
6
Sample Calculation – 5-Year MACRS
Year (n)
1
2
Calculation in %
(0.5)(0.40)(100%)
(0.4)(100%-20%)
SL = (1/4.5)(80%)
3
DDB
DDB
(0.4)(100%-52%)
MACRS (%)
20%
32%
17.78%
19.20%
DDB
SL = (1/3.5)(48%)
13.71%
4
(0.4)(100%-71.20%)
SL = (1/2.5)(29.80%)
Switch to SL
11.52%
11.52%
5
SL = (1/1.5)(17.28%)
SL
11.52%
6
SL = (0.5)(11.52%)
SL
5.76%
Contemporary Engineering Economics, 4th
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Comparison between DDB with
Switching to SL and MACRS Method
Contemporary Engineering Economics, 4th
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MACRS for Real Property
Types of Real Property
• 27.5-year (Residential)
• 39-year (Commercial)
• SL Method
• Zero salvage value
• Mid-month convention
•Example: Placed a residential property in service in March.
Find the depreciation allowance in year 1.
D1 = (9.5/12)(100%/27.5)
= 2.879%
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edition, © 2007
Depreciation Allowances for a 10-year
Ownership of the Property
Year (n)
Calculation
Allowed Depreciation (%)
1
(9.5/12)(100%/27.5)
2.8788%
2
100%/27.5
3.6364%
3
100%/27.5
3.6364%
4
100%/27.5
3.6364%
5
100%/27.5
3.6364%
6
100%/27.5
3.6364%
7
100%/27.5
3.6364%
8
100%/27.5
3.6364%
9
100%/27.5
3.6364%
10
(11.5/12)(100%/27.5)
3.4848%
Assume that the property will be sold in December of the10th year.
Contemporary Engineering Economics, 4th
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Depletion


Unlike depreciation and amortization, which
mainly describe the deduction of expenses
due to the aging of equipment and property,
depletion is the physical reduction of natural
resources.
Two types of depletion:


Cost depletion
Percentage depletion
Contemporary Engineering Economics, 4th
edition, © 2007
Cost Depletion


Concept: Units-of-production method
Cost depletion formula:
Depletion allowance = (Number of units sold)
Adjusted Basis

Total number of recoverable units

Example 9.10: Cost basis = $120,000, total recoverable volume =
1.5MBF, amount sold this year = 0.5 MBF
Depletion allowance = 0.5 MBF 
$120,000
1.5 MBF
 $40, 000
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Percentage Depletion


Concept: Based on a prescribed percentage of the gross income
from the property during the tax year
Example 9.11:


Given: Basis = $30 million, total recoverable volume = 300,000 ounces
of gold, amount sold this year = 45,000 ounces, gross income =
$16,425,000, and this year’s expenses before depletion = $12,250,000
Find: Maximum depletion allowance








Gross income from sale of 45,000 ounces
Depletion percentage
Computed percentage depletion
$16,425,000
x 15%
$ 2,463,750
Gross income from sale of 45,000 ounces
Less mining expenses
Taxable income from mine
Deduction limitation
Maximum depletion deduction
$16,425,000
12,250,000
$ 4,175,000
x 50%
$2,088,000
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Allowable
percentage
deduction
Calculating the Allowable Depletion
Deduction for Federal Tax
$2,463,750
$2,088,000
$2,088,000
 $30, 000, 000 
Cost depletion = 
 (45, 000)
 300, 000 
 $4,500, 000
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$4,500,000
Summary 1


Because it employs accelerated methods of
depreciation and shorter-than-actual depreciable
lives, the MACRS (Modified Accelerated Cost
Recovery System) gives taxpayers a break: It
allows them to take earlier and faster advantage
of the tax-deferring benefits of depreciation.
The total amount of taxes to pay remains
unchanged regardless of depreciation methods
adopted. It only changes the timing of the
payment.
Contemporary Engineering Economics, 4th
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Summary 2
• Many firms select straight-line
depreciation for book depreciation
because of its relative ease of
calculation.
 Given the frequently changing nature of
depreciation and tax law, we must use
whatever percentages, depreciable
lives, and salvage values mandated at
the time an asset is acquired.
Contemporary Engineering Economics, 4th
edition, © 2007