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.
Article By Shannon Sand and Jack Davis, South Dakota State University Extension