 Makers' depreciation. How is the depreciation deduction figured? Part number two. Let's do some wealth preservation with some tax preparation. Most of this information comes from publication 946, How to Depreciate Property Tax Year 2022. You can find on the IRS website irs.gov, irs.gov. Support Accounting Instruction by clicking the link below, giving you a free month membership to all of the content on our website, broken out by category, further broken out by course, each course then organized in a logical, reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems, PDF files and more like QuickBooks backup files when applicable. So once again, click the link below for a free month membership to our website and all the content on it. Looking at the income tax formula, we're focused on line one income. Remember in the first half of the income tax formula is in essence an income statement, but just an outline, other forms and schedules flowing into these line items. One of those, the schedule C having business income minus business expenses, the net business income from the schedule C flowing into line one income of the income tax equation. First page of the form 1040 noting that the schedule C generally rolls into the schedule one, generally rolls into the first page of form 1040 line number eight. The schedule C is the profit or loss from business income statement format, having an income and expense section. We are focused on the expense side of things here and more precisely on the depreciation, remembering that even if you have a cash based system, you're going to have to deviate to an accrual type thing for the purchase of equipment, putting it on the books in essence as an asset allocating the cost over the useful life importance, not with generally accepted accounting principles in this case, but with the tax code mainly focusing this time on the maker's depreciation. Also noting that we could have other things involved like the 179 and special deductions that you kind of have to layer on top of this conceptually as well. Our general rule is that we would like to get the deduction sooner rather than later unless we have some reason to do it otherwise. For example, having higher income tax brackets in future years due to having increased income may be a reason to deviate from the general rule. All right. So now we're continuing on with the maker's depreciation here. So sale or other disposition before recovery period ends. So if you sell or otherwise dispose of your property before the end of its recovery period, your depreciation deduction for the year of the disposition will be only part of the depreciation amount for the full year. All right. So we talked about, you know, the depreciation methods for makers is in essence an accelerated depreciation method, meaning we depreciation more than in the early years than the latter years. Well, what happens if I sell the property? Now remember, this is not inventory we're talking about. We didn't buy it for the purpose of selling it to generate revenue. We bought it to use it in the business, but we might still end up selling it before it's fully depreciated. And at that point, then you might have to calculate the gain or the loss on the sale, which gets a little messy in and of itself because it's likely or more likely that we're going to end up with a gain when we sell it because of the accelerated depreciation method. We took more depreciation upfront, lowering the basis and the sales amount that we're going to have is going to be the cost minus the adjusted basis, which is now going to be lower because of the accelerated depreciation method. So these methods often lead to a bigger gain, which causes other problems because then the question is, do you have to calculate the gain as ordinary income or capital gain? So that's one issue. The other issue with regards to simply depreciation is that now if you sold it in the middle of the year, you have a partial year of depreciation up until the point it was sold. You didn't have it for the full year, but you still would think you'd need to calculate how much of the year you got to be able to depreciate for that year of disposal. All right, you have disposed of your property. If you have permanently withdrawn it from use in your business or income producing activity because of its sale, exchange, retirement, abandonment, involuntary conversion or destruction. So however you got rid of it, you sold it, you just abandoned it, you threw it away, you disposed of it, whatever. Same kind of treatment for depreciation purposes in essence. After you figure the full year depreciation amount, figure the deductible part using the convention that applies to the property. So you have the half year convention. So the conventions are coming into play again. Remember when we buy the property, these conventions were dictated by the type of method that we're using and the type of property that we're using. And the default oftentimes is that half year convention. So if I buy it, the thought process is that the convention is that I record that in the middle of the year, no matter when I bought it. Now we're selling it, that half year convention you would think would apply as well to the tail end of the transaction, meaning we assume that we sold it in the middle of the year even if we sold it at some other time. So the property for which you used a half year convention, the depreciation deduction for the year of the disposition is half the depreciation determined for the full year. So mid-quarter convention. So now if you had to use the mid-quarter convention, then you're going to assume you sold it in the middle of the quarter, whatever quarter. So for property for which you used the mid-quarter convention, figure your depreciation deduction for the year of the disposition by multiplying a full year of depreciation by the percentage listed below for the quarter in which you dispose of the property. So now you've got your tables here and the percentage for first, second, third and fourth quarters. Example, let's check it out. On December 2, 2019 you placed in service an item of five year property costing $10,000. You did not claim a section 179 deduction and the property does not qualify for a special depreciation allowance, your unadjusted basis for the property is $10,000. So you used the mid-quarter convention because this was the only item of business property you placed in service in 2019 and it was placed in service during the last three months of your tax year. So you had to use the mid-quarter instead of the half year. So your property is in the five year property class. So you use table A5 to figure your depreciation deduction. Your deductions for 2019, 2020 and 2021 were 500, 5% times 10,000, 3,838% times 10,000 and 2,280, 22.8% times 10,000 pulled from the tables. So you dispose of the property in April 6, 2022 to determine your depreciation deduction for 2022, first figure the deduction for the full year. This is 1,368, which is the 13.68 from the table times the 10,000. April is the second quarter of the year. So you multiply 1,368 by 37.5 or 0.375 to get your depreciation deduction of 513 for 2022. Now again, the software is quite helpful to do these calculations for you when you make the disposition but you want to conceptually understand these ideas as well so you can make projections out into the future. So mid-month convention and explain this kind of stuff to clients as well. Mid-month convention used. So if you dispose of residential rental or non-residential real property, figure your depreciation deduction for the year of the disposition by multiplying a full year of depreciation by a fraction. So now you've got a mid-month convention typically used in real estate situations. So the number of the fraction is the number of months including partial months in the year that the property is considered in service. The denominator is 12. So obviously a ratio kind of situation if you sold it in the middle of the year at 12 being the bottom line of the ratio. So example, let's check it out. On July 2nd, 2020, you purchased and placed in service residential rental property. The property cost $100,000, not including the cost of land. So we're just talking building here because that's the depreciable part. You use table A6 to figure your maker's depreciation for this property. You sold the property on March 2nd, 2022. You filed your tax return based on the calendar year. A full year of depreciation for 2022 is 3,636. This is 100,000 multiplied by the .03636, the percent for the seventh month of the third recovery year. That's from the table. That's the full depreciation for the year. You then apply the mid-month convention for the 21 over two months of use in 2022. So treat the month of disposition as one-half month of use. So multiply 3,636, the full depreciation by the fraction, which is 2.5 over 12, right? 2.5 over 12, the ratio to get your 2022 depreciation deduction of 757.50. All right, figure the depreciation without using the tables. You're on the dining table. Table. Table. Instead of using the rates and the percentage tables to figure your depreciation deduction, you can figure it yourself if you want or use tax software, might be helpful. Before making the computation each year, you must reduce your adjusted basis in the property by the depreciation claimed the previous year. So now it gets a little bit more complex because we're not just multiplying the basis times a table number. We have to do the declining balance method calculations, which are a little bit more complex. So declining balance method, when using a declining balance method, you apply the same depreciation rate each year to the adjusted basis of the property. So the problem here is that you have to adjust the basis of the property to apply the same rate to it, which adds another level of kind of calculation as opposed to using the tables, which always use the base amount at the beginning. So you must use the applicable convention for the first tax year, and you must switch to the straight line method beginning in the first year for which it give an equal or greater deduction. In other words, you're using this double rate as long as it's higher than the straight line rate, which is funny because again, the double declining balance method allows you to depreciate more upfront, but it's not perfect in calculation. So it doesn't actually come out completely even. So you kind of fudge the end of it going back to straight line when that makes more sense. And then you don't depreciate over the cost of the property, so you don't over depreciate it. So the straight line method is explained later. Okay, so you figure depreciation for the year you place the property and service as follows. Number one, multiply your adjusted basis in the property by the declining balance rate. So number two, apply the applicable convention. So the mid-year, mid-quarter, whatever. You figure depreciation for all other years before the year you switch to the straight line method as follows. So year two is often the place where it gets messy, right? Because then you got to do more than just multiplying times the first rate. Number one, reduce your adjusted basis in the property by the depreciation allowed or allowable in earlier years. Meaning you have to have the adjusted basis after the depreciation you already took. And then number two, multiply this new adjusted basis by the same declining balance rate used in earlier years. All right, if you dispose of property before the end of its recovery period, see using applicable convention later for information on how to figure depreciation for the year. You're disposed of it. Figuring depreciation under the declining balance method and switching to the straight line method is illustrated in example one later. All right, declining balance rate. So if you figure your declining balance rate by dividing the specified declining balance percent, 150 or 200 percent charge to a decimal, change to a decimal by the number of years in the property's recovery period. So for example, you have three year property depreciated using the 200 percent declining balance method. Divide to 200 percent by three to get the .6667 or 66.67 percent declining balance rate for 15 year property. Depreciate the 150 percent declining balance method. Divide 1.5 or 150 percent by 15 to get .1 or 10 percent declining balance rate. And the following table shows the declining balance rate for each one. So in other words, it's sometimes it's useful to kind of see an example of these items. Like for example, if you took a piece of property for $1,000 piece of property that you had to depreciate, and let's say that you were depreciating it straight line over three years. So if I divide that by three years, that would be this much 333.33 per year. So what's the rate then? If I take that amount divided by the cost of 1,000, it would be 33.33 percent. In other words, if I malt 33.33 percent times the 1,000, there's the 333.33 straight line. Now the double declining then is going to take that straight line amount. So once again, I had 100,000 divided by three years. Is that divided by the 1,000? If I take that rate and multiply it times two, I get the double declining rate. Because now I just basically took the straight line rate and doubled it. Now you can get there. They're kind of giving you a shortcut way to get there. Like one way you can think about it is if I take one divided by three, I'm going to get the straight line rate. That's another way you can get to the straight line rate times two. And that'll give you to the double declining rate. Right. If I take the five year property one over five is the straight line rate times two is going to give you the 40, the double declining rate. One divided by seven is the straight line rate over here. If I say times two, we get that. So that's the general idea. But sometimes it's easy just to look at an actual number. I'm going to depreciate 10,000. And I'm going to start straight line and think about what that looks like and then adjust it. Let's do five year. And I'll say if I take that and I was going to do straight line over five years divided by five, it would be 2,000 a year. 10,000 divided by the 10,000 would be 0.2 percent straight line each year. If I double that then times two, then I'm going to get to that 40. That's kind of what we're happening. We're doubling the straight line rate that you would calculate kind of in the first year. Okay. So straight line method. When using the straight line method, you apply a different depreciation rate each year to the adjusted basis of your property. You must use the applicable convention in the year you place the property in service and the year you're disposed of the property. You figure depreciation for the year you place the property in service as follows. Number one, multiply your adjusted basis in the property by the straight line rate. And two, apply the applicable convention. So notice when you think about the straight line rate, usually you could say I'm going to multiply times the straight line rate like that 10,000 times 2.2 right for the 2000. But you probably more likely would think about it as 10,000 divided by the useful life, right, which would be, you know, whatever five years and then you'd have to deal with a convention. Is there a half year convention kind of thing, right? So you figure depreciation for all other years, including the year you switch from the declining balance method to the straight line method as follows. Number one, reduce your adjusted basis in the property by the depreciation allowed or allowable in earlier years under any method to determine the depreciation rate for the year. Three, multiply the adjusted basis figured in one by the depreciation rate figured in two. If you dispose of property before the end of its recovery period, see using the applicable convention later for information on how to figure depreciation for the year you dispose of it. Straight line rate. You determine the straight line depreciation rate for any tax year by dividing the number one by the number one by the year's remaining in the recovery period at the beginning of that year. So that's kind of what we did when we figured the straight line and then we doubled it. So one divided by how many years remaining. When figuring the number of years remaining, you must take into account the convention used in the year you place the property in service. If the number of years remaining is less than one, the depreciation rate for that tax year is one. So in other words, it might be at the end of the period where you have that half year convention taking place, so it might not be a full year in that case. Using the applicable convention. The applicable convention discussed earlier under which convention applies affects how you figure your depreciation deduction for the year you place your property in service and for the year you dispose of it. So it determines how much of the recovery period remains at the beginning of each year. So it also affects the depreciation rate for property you depreciate under the straight line method. The straight line rate is the previous in the previous discussion used the applicable convention as explained in the following discussions. Alright, so we have these conventions again, mid quarter, half year, mid month. We're talking now half year convention, most likely the most common one. So if this convention applies, you deduct a half year of depreciation for the first year and the last year that you depreciate the property. Now note that this actually gets a little bit confusing because in the first year, so what you're telling me here is like, if I had a double, if I had a double declining balance rate and a half year convention, the first year would result to be like a straight line with no half year convention. In other words, for example, the thing that's kind of funny here is if I had a ten thousand dollar piece of item I'm putting on the books and let's say it's five year property. So if I say divided by divided by five, you would say two thousand a year if I was doing a straight line method with no convention, if it was a half year convention, I would divide that by two. But if it was a double, if it was a double declining balance being used, I would take that divided by divided by the ten thousand. There's two percent or I'm sorry, point two or twenty percent. If I multiply that times two, my double declining rate is forty percent. So now if I was using a double declining half year convention, I would take the forty percent times the ten thousand dollar cost. I would get four thousand twice as much for that year, but it would be a half year convention. So I would take that and divide it by two to get back to two thousand, which looks like that's the straight line method, but it's not because it's the double declining method with a half year convention. So when you see that it often throws people off in that first year because of that half year convention, it looks like you're using the straight line. When it wasn't, it was double declining with a half year convention. Okay. So figure your depreciation deduction for the year you place the property in service by dividing the depreciation for the full year by two. If you dispose of the property before the end of the recovery period, figure your depreciation deduction for the year of the of the disposition the same way. If you hold the property for the entire recovery period, your depreciation deduction for the year that includes the final six months of the recovery period is the amount of your unrecovered basis in the property. All right. Mid-quarter convention. If this convention applies, the depreciation you can deduct for the first year you depreciate the property depends on the quarter in which you place the property in service. So now it's more complex than a mid-year convention because now you've got four quarters that you have to deal with instead of just half the year. So a quarter of a full 12 month tax year is a period of three months. So 12 divided by four is three months is a quarter, has three months in it. The first quarter in the year begins on the first day of the tax year. The second quarter begins on the first day of the fourth month of the tax year. The third quarter begins on the first day of the seventh month of the tax year. The fourth quarter begins on the first day of the tenth month of the tax year. So a calendar year is divided into the it into the following quarters, 1st, 2nd, 3rd, 4th, and then you've got 3 month period, January, February, March and 1st quarter, April, May, June, 2nd quarter, July, August, September 3rd, October, November, December and the 4th. So figure your depreciation deduction for the year you place the property in service by multiplying the depreciation for a full year by the percent listed below for the quarter you place the property in service. So if you put it in like the fourth quarter, right, you'd get, you'd get, you have to take the full depreciation instead of dividing by two, you got to multiply by, by the 12.5%. Right. So you, and you would think that, for example, if I had the, if I had the depreciation for the full year that came out to the, the, the 1,000, then I'd have to, you would, you would think that if I, if I got like, if I only got the fourth quarter, if I bought it in the fourth quarter and you're only giving me a quarter of depreciation, you would think that I would be able to, to take the ratio of taking that times, times the ratio, well, let's just do it this way. It would be three over 12, right, would, would be the 25%. And then you'd have to take that and divide it by two, because it was the middle of the quarter. And that's where you get that 12.5. Right. So if I bought it in the, in the last quarter, October through December, you're getting half of, of the last quarter. So that's basically how you're, you're kind of deriving these percentages. Okay. So, so if you depreciate, if you dispose of the property before the end of the recovery period, figure your depreciation deduction for the year of the disposition by multiplying a full year depreciation by the percentage listed below for the quarter you dispose of the property. Similar idea. If you hold the property for the entire recovery period, your depreciation deduction for the year that includes the final quarter of the recovery period is the amount of your non recovered basis in the property. So mid month convention. So now we're down to the mid month convention, usually with the real estate property. So if this convention applies to depreciation, you can deduct for the first year that you depreciate the property depends on the month in which you place the property in service. Figure your depreciation deduction for the year you place the property in service by multiplying the depreciation for a full year by a fraction. The number of the fraction is the number of full months in the year that the property is placed in service plus one half or point five. So the denominator is 12. So if you dispose of the property before the end of the recovery period, figure your depreciation deduction for the year of this position the same way. If you hold the property for the entire recovery period, your depreciation deduction for the year that includes the final month of recovery period is the amount of your unrecovered basis in the property. Let's look at an example. That was confusing. So you use the calendar year and place the non residential real property in service in August. The property is in service for four months September, October, November and December. So your numerator is 4.5 the four months plus point five because it's a mid month convention. So you multiply the depreciation for the full year by the ratio of the four point five months for full months plus the mid month convention over 12 12 months in a year that gives you the point three seven five