Depreciation is an important part of keeping records in agriculture. Depreciation is a reduction in the value of an asset over time, due to wear and tear. Things such as tractors, trailers, etc. all depreciate over time. Depreciation is also a way to make an income tax deduction to recover the cost of qualifying assets. Careful consideration of how to report tax depreciation helps producers comply with IRS regulations and can result in a reduction of income taxes paid. Most farmers and ranchers are familiar with the concept of depreciation; however, depreciating an asset for tax purposes is different than calculating depreciation for financial statements and management decisions.
Economic depreciation is the annual reduction in the economic value of the asset because of use, wear, tear or age. Depending on the asset, depreciation results from a combination of some or all of these issues. In order for an asset to be depreciable, it must: 1) be owned, 2) have a useful life greater than one year, 3) have a limited and determinable life, and 4) have an industrious use in the business. Economic depreciation is based on the matching principle of accounting which means that the cost of the property expensed in a period should match the reduction in the property’s value occurring in the same period. For example, if a tractor consistently loses 10% of its value on an annual basis, its annual depreciation expense should approximate 10% of its depreciable value.
In agriculture, examples of assets which can be depreciated includes buildings, vehicles, machinery, equipment, fences and other land improvements, as well as, breeding livestock. Real estate, market livestock, crop inventories, and supplies are not depreciable. Depreciation calculations utilize the asset’s original cost (i.e., basis), and require business managers to estimate salvage value and useful life. The cost of an asset is generally its purchase price. For assets without a purchase price (e.g. raised breeding livestock), fair market value is used as the asset’s beginning basis. There exist several common methods for calculating economic depreciation. The method used for depreciating an asset will depend on the asset to be depreciated. Economic depreciation appears on an accrual income statement as an expense and is used to calculate an asset’s depreciated value or book value for the cost-basis balance sheet.
Tax depreciation is the depreciation which can be listed as an expense on a tax return for a given period under valid IRS rules. Tax depreciation sanctions reclamation of the cost of an asset while it is being used to create revenue. The IRS often permits businesses, including farms and ranches, to hasten tax depreciation expense by taking more depreciation in the first few years of a property’s life, and less depreciation later on. For example looking at the previous tractor example, an illustration of hastened depreciation would be a deduction amount equal to 20% of value in the first year and 15% in the second. Accelerated depreciation can result in significant tax savings in the early years of an asset’s life compared with non-accelerated depreciation. It is important to be aware, however that the value will be much lower later on in the taxable useful life of the asset.
The Modified Accelerated Cost Recovery System (MACRS) is used to depreciate or recover for tax purposes the basis of most property placed in service after 1986. The MACRS consists of two depreciation systems, the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). The systems use different methods and recovery periods for calculating depreciation in general. Farmer’s and rancher’s use GDS unless required by law to use ADS, or they elect to use ADS. Normally, ADS results in slower depreciation than GDS which is one reason why it is not frequently used. However, producers desiring to delay some depreciation to later years should consider ADS. To compute depreciation under MACRS, producers must determine the depreciation system, property class, placed in service date, basis value, recovery period, convention that applies, and depreciation method that applies. Producers can calculate depreciation themselves, or they can use a depreciation table provided by the IRS in Appendix A of the How to Depreciate Property publication.
Property Classes under GDS
GDS clusters assets into nine property classes: 3-year property, 5-year property, 7-year property, 10-year property, 15-year property, 20-year property, 25-year property, residential rental property, and nonresidential real property. These property classes govern recovery periods. The recovery period is the number of years over which the asset’s cost or other basis is recovered. For example, most agricultural machinery and equipment will be in the 7-year class and have a 7-year recovery period. Automobiles and trucks are in the 5-year class but tractor-trailer units are in the 3-year class. Purchased dairy and beef breeding cattle are in the 5-year class; while breeding swine are in the 3-year and horses are in the 7-year classes. Single use agricultural buildings are in the 10-year class, certain improvements to land are considered 15-year property, and other farm and ranch buildings are 20-year property. The recovery periods of property are generally longer under ADS than under GDS.
Depreciation Methods for Farm and Ranch Property
MARCS provides three depreciation methods under GDS and one method under ADS.
- The 200% declining balance method over a GDS recovery period.
- The 150% declining balance method over a GDS recovery period.
- The straight line method over a GDS recovery period.
- The straight line method over an ADS recovery period.
The straight line method has a constant depreciation value for each year; with the exception of the first and last year, but this is dependent upon the convention applied. For example, property with a 10-year recovery period will depreciate 10% per year using straight line. Declining balance is an accelerated method of depreciation used to generate larger tax deductions in the assets’ earlier years. Declining balance starts with the annual percent reduction in value from the straight-line method, and then multiplies that by either 200% or 150%.
Farmers and ranchers who have placed property into service after 1988 generally depreciate it under GDS using the 150% declining balance method. Exceptions are farmers and ranchers who elect to depreciate property under ADS or GDS using the straight line method. The straight line method generally results in slower depreciation than does declining balance. Slower depreciation may be preferred by a producer who anticipates higher taxable income and a higher marginal tax rate in future years, compared to the near term.
Property is generally qualified for depreciation when first placed into service. Depreciation ends when the cost or basis of the asset is fully recovered, or the property is removed from use, whichever comes first. Under MARCS however, convention governs when an asset’s recovery period commences and ends. The convention used regulates the number of months for which depreciation is claimed during the year the property is first placed into use, and the year the property is removed from use. Most property will include a half year of depreciation for the year of purchase, regardless of the purchase date (called the half-year convention). It applies unless more than 40% of the depreciable assets purchased in a year were purchased in the last 3 months of the tax year. In that case, the mid-quarter convention rule applies. The mid-quarter convention provides for 1.5 months of depreciation for the quarter the property was placed into service or removed from use. MARCS also includes a convention called mid-month but it seldom applies to farm or ranch property.
Electing 179 Depreciation
Section 179 of the IRS tax code exists as an alternative to depreciating capital purchases over time. This allows businesses to deduct from taxable income all or part of the purchase price of new and used capital equipment and software in the year the items were acquired. The value of items eligible for the deduction is subject to dollar limits and items must have been placed into service in the tax year the deduction is being taken. The total amount a person can elect to deduct under section 179 is subject to a dollar limit and business income limit. These limits apply to each tax payer, and not to each business. If you purchase and have more than one item of qualifying property during the year, you can allocate the section 179 expense deduction among the items in any way, as long as the total deduction does not exceed the maximum. You cannot carry costs in excess of the $500,000 limit over to future years. Exceeding this purchase limit reduces the Section 179 deduction allowed on a dollar-for-dollar basis. Section 179 has a reduced dollar limit for costs exceeding $500,000. This means that if the cost of the asset placed into service in 2016 exceeds $500,000, the producer must reduce the dollar limit (but not below zero) by the amount of cost over $500,000. The producer cannot carry over any of the costs that exceed the reduced limit. Producers may elect the Section 179 expense deduction instead of recovering the cost by taking annual depreciation deductions.
How this method of depreciation affects tax deduction amounts can be seen in Table 1. The example shows the annual reduction in taxable income using four depreciation methods applied to a tractor with a purchase price of $100,000. Table 1 also shows deduction amounts using GDS declining balance 150%, GDS straight line, ADS straight line, and Section 179. These examples were calculated using the half-year convention. Note that depreciation with 150% declining balance switches to straight line when straight line results in a higher percentage amount. Also note that ADS straight line uses a longer recovery period than GDS straight line.
Table 1. Annual Depreciation Amounts by Depreciation Method, $100,000 Tractor
Table 1 also shows that the 150% declining balance method results in more depreciation in early years than straight line over a GDS recovery period. Also, straight line over the longer recovery period of ADS results in less depreciation each year than straight line over a GDS recovery period. Section 179 allows the full purchase price of the tractor to be deducted from taxable income in the first year of service. When choosing a depreciation method for tax purposes farmers and ranchers should consider the effects of depreciation on taxable income over time.
Depreciation and Section 179 expense is elected by completing Form 4562. Instructions for completing Form 4562 are on the IRS website.
For further tax information, please see:
For questions concerning tax depreciation unique to your situation, consult your personal tax preparer or attorney.
Disclaimer: The information in this article is believed to be reliable and correct. However, no guarantee or warranty is provided for its accuracy or completeness. This information is provided exclusively for educational purposes and any action or inaction or decisions made as the result of reading this material is solely the responsibility of readers. The author(s) and South Dakota State University disclaim any responsibility for loss associated with the use of this information.