What it means
When a business buys equipment, the tax rules do not let it deduct the whole cost at once, except where special elections apply. Instead the cost is spread over a set recovery period.
MACRS provides the schedule, and because more of the deduction comes early, it lowers taxable profit sooner than straight-line depreciation would. Assets are sorted into classes with recovery periods such as 3, 5, 7, 10, 15 and 20 years for most equipment, while buildings use longer straight-line periods.
Computers, cars and light trucks usually fall in the 5-year class, and most office furniture and general machinery in the 7-year class. The tax authority publishes the class lives and the percentage tables.
The tables apply a convention for the timing of purchase. Under the common half-year convention, an asset is treated as if it was placed in service in the middle of the year, so the first year gets a half-year of depreciation.
That is why a 5-year asset is actually deducted over six tax years. For a finance manager, MACRS creates a difference between tax depreciation and book depreciation.
The company may show smaller, straight-line charges in its accounts but claim larger MACRS deductions on its tax return. The gap is recorded as a deferred tax liability, which is tax postponed rather than avoided.
Several related rules can change the answer. Immediate expensing provisions and bonus depreciation, which the tax authority sets and changes from time to time, may allow a bigger deduction in year one.
Check the current provisions before building a forecast. The main benefit is the time value of money, because a deduction taken today is worth more than the same deduction taken years from now.
Businesses usually weigh this against the administrative cost of keeping separate tax and accounting records.
In practice
Real-world examples.
Example
A print shop buys a $50,000 press that is classed as 5-year property. Using the table, it deducts $10,000 in the first year and $16,000 in the second, which cuts its taxable profit sooner than a straight-line schedule would.
Example
A restaurant group buys $140,000 of kitchen equipment in the 7-year class. Its accountant records the tax schedule in a separate fixed asset register, because the figures differ from the straight-line charges in the published accounts.
Example
A software start-up buys laptops costing $20,000 in total. Because they fall in the 5-year class, the tax deduction in the first year is 20,000 x 0.20 = $4,000, unless the company elects to expense the full cost under a separate rule.
Formula
Calculation
Annual depreciation = Cost of asset x MACRS table percentage for that year
A company buys equipment for $50,000 in the 5-year class using the half-year convention. The table percentages are 20%, 32%, 19.2%, 11.52%, 11.52% and 5.76%. Year 1 = 50,000 x 0.20 = $10,000. Year 2 = 50,000 x 0.32 = $16,000. Year 3 = 50,000 x 0.192 = $9,600. Year 4 = 50,000 x 0.1152 = $5,760. Year 5 = $5,760. Year 6 = 50,000 x 0.0576 = $2,880. The total is 10,000 + 16,000 + 9,600 + 5,760 + 5,760 + 2,880 = $50,000.Case study
Seen in the real world.
Ironwood Fabrication is an illustrative, fictional manufacturer that bought a $400,000 machine in the 7-year class. Its tax adviser prepared a schedule showing that the first-year MACRS deduction of 14.29% of the cost was about the same as the straight-line charge used in the accounts, but that the deductions in years two and three were substantially higher.
In the second year the table gave 24.49%, or $97,960, compared with $57,143 on a straight-line basis. At a tax rate of 25%, the extra deduction saved the fictional company about $10,200 of tax in that year. The finance director explained to the board that the saving was a timing benefit, and that tax would be higher in later years when the deductions ran out.
She booked the difference as a deferred tax liability and used the cash to reduce the overdraft. The illustrative lesson was that accelerated tax depreciation is useful for cash flow, but it does not reduce the total tax over the asset's life.
Watch out
Common mistakes.
- Believing MACRS depreciation must also be used in the published accounts, when accounting standards often require a different method.
- Forgetting the half-year convention, and expecting a 5-year asset to be fully depreciated in five years.
- Treating accelerated deductions as a permanent tax saving, when they mostly shift the timing of deductions.
Questions
People also ask.
What does the half-year convention mean?
It treats an asset as placed in service in the middle of the year, so the first and last years each receive half a year of depreciation.
Does land qualify?
No, land is not depreciable, though buildings and improvements on the land can be depreciated over the periods set by the tax authority.
How is MACRS different from straight-line depreciation?
MACRS front-loads deductions into the early years, while straight-line spreads the same cost evenly across the life of the asset.
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