Recording the decline in value of an asset over its useful life is the basis of depreciation. Calculating the depreciation of an item gives a business or individual a tax deduction each year for the life of the item. There are two ways to calculate depreciation: straight line and accelerated. No matter how you choose to calculate depreciation, the start date is very important. The IRS places guidelines on the timeframe surrounding the start of the depreciation. This prevents large deductions being taken for end-of-year purchases.
When Depreciation Starts
If you buy a car then depreciation starts the moment you drive it off the lot. For business purposes, however, depreciation starts when an item is placed into service. In order to claim a tax deduction, the item must officially start usage before the end of the tax year. For tax purposes, most businesses utilize the Modified Accelerated Cost Recovery System (MACRS) to calculate depreciation. There is also a Section 179 deduction that allows the user to take the entire deduction as long as the item becomes usable during the tax year. For items using MACRS, the timing of the service date is very important, as is the type of asset. Real estate carries slightly different tax treatments as to the beginning of depreciation.
Non-residential real estate such as office buildings, warehouses and stores receive a mid-month depreciation basis. Essentially, no matter what time of the month the property begins usage, the start date is the middle of the month. Filers receive a deduction for half a month as well as the remaining months of the year. For example, a warehouse purchase on Jan. 2 would receive a deduction of 11 1/2 months for the tax year. The IRS provides depreciation tables so that tax filers do not have to calculate the deprecation on their own.
Property other than real estate follows the half-year convention rules. This convention mandates that no matter when the item is placed into service, it is treated as if it began use in the middle of the year. This gives the tax filer a half-year deduction despite the actual start date. There will still be a half year of deduction to claim after disposal of the item. Tax preparers can find half-year convention tables on the IRS website. Most computer accounting systems automatically calculate the conventions for tax use.
To prevent filers from deducting a half year of depreciation, the IRS requires usage of the mid-quarter convention rules for purchases made in the last quarter of the year. The mid-quarter rules apply if more than 40 percent of the assets placed in service during a given year occurred in the last quarter. These rules do not apply to real estate. The mid-quarter convention rules only apply to depreciable assets using the MACRS method of calculation. If you purchase more than 40 percent of your assets in the last quarter then the mid-quarter rules apply to all assets acquired during the year. The mid-quarter rules allocate the percentage of depreciation allowable for each quarter of the year:
First quarter: 87.5 percent Second quarter: 62.5 percent Third quarter: 37.5 percent Fourth quarter: 12.5 percent
Depending on an item’s beginning date of service, the filer uses the IRS mid-quarter chart to calculate the depreciation. You can avoid the mid-quarter convention rules by purchasing larger, more expensive assets earlier in the year and balancing other purchases throughout the year.