Allowed depreciation refers to the depreciation that a business is allowed to deduct from its tax liabilities. The annual depreciation of assets needs to be considered while calculating an individual’s or company’s taxable income. It is because depreciation decreases the ordinary income of the taxpayer (which may be a company or individual) as a cost is incurred.
Some government regulations allow the taxpayer to charge depreciation on assets in order to avail a tax benefit. Depreciable assets such as property, plant, and equipment are grouped into different classes or blocks. Government bodies like the Internal Revenue Services (IRS) in the US publish depreciation schedules that are applicable to different blocks.
A schedule entails the exact percentage of deduction allowed per asset per annum and the number of years for which deduction is permitted. It, in turn, lowers one’s total taxable income, and consequently leads to lower tax liability.
What is Depreciation?
Depreciation is a business accounting method used to write off the cost associated with the use of an asset, as the value of any tangible or physical asset falls as it undergoes wear and tear throughout its life. Depreciation effectively lowers the adjusted cost basis of an asset, which is the remaining net cost of an asset after making all the adjustments for tax-related items.
There are two methods for evaluating depreciation: (1) the straight line method, and (2) the diminishing balance method. The former is fairly simple; the original cost of the asset is reduced by a fixed amount for every year the asset is deemed useful.
On the contrary, in the diminishing balance method, a fixed percentage depreciation rate is applied to the remaining net cost of the asset each period. Therefore, the depreciation is higher in the initial years and falls in subsequent years, theoretically matching the expected use of the asset.
In cases where a company sells or disposes of depreciable assets, and the sales price is larger than the adjusted cost base, then depreciation recapture occurs. The gain on sale is recorded as ordinary income as it represents the amount of depreciation expense previously taken on the asset, and taxed at the ordinary income tax rate.
If the sales price is larger than the original acquisition cost, the company will pay capital gains tax on that portion (more favorable rate) in addition to any tax on recaptured depreciation.
Consider a case where machinery purchased for $10,000 falls under the 20% depreciation rate per annum, deductible for four years. At the end of the fourth year, the machine was sold for $4,000.
Evaluate the original cost basis. The original cost basis is the price paid in order to acquire the asset, i.e., $10,000.
Evaluate the accumulated depreciation. The allowable depreciation expense incurred is 20% of $10,000 for 4 years, i.e., $8,000.
Determine the adjusted cost basis. The adjust cost basis is original cost basis less accumulated depreciation, i.e., $10,000 – $8,000 = $2,000.
Evaluate the depreciation recapture. The realized profit from the sale of the asset is selling price minus adjusted cost basis, i.e., $4,000 – $2,000 = $2,000.
Allowed Depreciation – Legal Structures
1. The United States of America
In the US, either the diminishing balance method or straight-line method of computation may be followed according to the Modified Accelerated Cost Recovery System (MACRS). According to the IRS, which is the US federal agency for tax collection, the asset classes for claiming depreciation are as follows:
No. of Years Permissible
Racehorses, Rent-to-own property
Office Furniture, Agricultural Machinery
Boats, Fruit Trees
Restaurants, Gas Stations
Farm Buildings, Municipal Sewers
Water Treatment Facilities
In India, depreciation is an allowable expense according to the Income Tax Act, 1961, and it can be done using the diminishing balance method. The assets are broadly categorized into furniture, plant, and machinery. The allowed rate of depreciation for furniture and fittings is 10%, while plant and machinery can be 15%, 30%, or 40%, depending on the item.The diminishing balance depreciation for groups with 3, 5, 7, and 10 years is 200% and those with 15- and 20-year classes are 150%.
3. The United Kingdom
According to the Income Tax Act, 2007 in the UK, deprecation is not considered to be an allowable expense while evaluating corporate tax by Her Majesty’s Revenue and Customs, the British Tax collection authority. It is replaced by capital allowances, wherein a fixed rate is used to determine how much of the cost may be deducted each year. There are three types of pools:
Main Pool at 18%, which includes plant and machinery.
Special Rate Pool at 8%, which includes “integral features” of buildings, items with long life, and thermal insulation of buildings and cars with CO2 emissions of more than 130g/km.
Single Asset Pools at either 18% or 8%, depending on the item.
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