Understanding MACRS Depreciation Method

Feb 6, 2025

MACRS Depreciation Method

Overview

  • MACRS: Modified Accelerated Cost Recovery System.
  • Current tax depreciation system in the U.S.
  • Allows faster cost recovery of capital equipment compared to the straight-line method.
  • Under MACRS, the capitalized cost (basis) of tangible property is recovered over a specified life with annual depreciation deductions.

Characteristics of MACRS

  • Salvage Value: Not deducted when calculating depreciation.
  • Faster recovery by deducting more in early years and less in later years compared to straight-line depreciation.

Property Classes

  • Different property classes specified by the IRS:
    • 3-Year Property: Includes special handling devices for food/beverage manufacturers, special tools for plastic products.
    • 5-Year Property: Information systems (computers and peripherals), petroleum drilling equipment.
    • Other classes include 7, 10, 15, and 20 years.
  • Depreciation schedules based on asset class.

Depreciation Schedules

  • 3, 7, 10-Year Classes: Use 200% declining balance.
  • 15, 20-Year Classes: Use 150% declining balance.
  • Convert to straight-line depreciation in optimal years (e.g., year 3 for 3-year equipment).

Half-Year Convention

  • Assumes property is put to use on July 1st, allowing for half-year depreciation in the first and last year.
  • Results in an additional year on paper (e.g., 4 years for a 3-year schedule).

Example Calculation

  • Equipment Cost: $1,000,000
  • Salvage Value: $200,000 (not subtracted for depreciation)
  • Useful Life: 5 years
  • Tax Rate: 35%

Yearly Depreciation & Book Value

  • Year 1: 20% depreciation ($200,000), Book Value: $800,000
  • Year 2: 32% depreciation ($320,000), Book Value: $480,000
  • Continues reducing book value until $0.

After-Tax Salvage Value Calculation

  • Selling Price in Year 3: $425,000
  • Book Value in Year 3: $288,000
  • Capital Gain: Sale Price - Book Value = $137,000
  • Taxes on Gain: 35% of $137,000 = $47,950
  • After-Tax Salvage Value: $425,000 - $47,950 = $377,050

Summary

  • MACRS allows faster cost recovery than straight-line depreciation.
  • Useful for reinvestment into new equipment, plants, and jobs.
  • IRS prescribes useful life and schedules.
  • Half-year convention affects the number of years on paper.
  • Essential method for tax and cash flow analysis.