In this video, I want to discuss the MACRS depreciation method, which stands for Modified Accelerated Cost Recovery System. And it's the current tax depreciation system in the United States. And under this system, the capitalized cost, or the basis of the tangible property, is recovered over a specified life by annual deductions for depreciation.
and the lives are specified broadly in the Internal Revenue Code. What it does is it allows firms to recover the costs of capital equipment faster than the straight-line approach. In a previous video, I've discussed straight-line depreciation, which is simply you deduct the same amount every year. Here you're going to deduct more in early years and less in later years.
One of the things that you should note that's different about MACRS versus straight-line the straight line approach is the salvage value is not deducted when doing the calculations. This seems to be a common mistake that is made when people do the depreciation schedule. Right here I'm going to show you an example of some of the property classes. There are actually more, but I couldn't squeeze them all into a slide that would be readable on the video.
There's three-year property and some of the things that fall under three-year property are special handling devices for food and beverage manufacturer, special tools for the manufacturer of finished plastic products, etc. There's five-year property, information systems like computers and peripherals, petroleum drilling equipment, etc. So the IRS specifies what table you should use for the depreciation.
So you don't make it up. You don't decide, okay, I'm going to use five years for... you know my other office furniture no they say that seven-year property so you have to go with whatever they tell you you should be using this is what the table looks like K again I've only shown you a few of them three or five years seven-year but there are other depreciation schedules based on the asset class there are few footnotes here three 7 and 10 year classes use 200% and the 15 and 20 year classes use 150% declining balance depreciation, which is a depreciation method. You may have covered in accounting class double declining balance and there are again another accelerated depreciation approach.
They point out that all classes convert to straight line depreciation in the optimal year shown with the asterisk. for three-year equipment that's in year three for five-year that's in year four for seven year that's in year five. You'll notice that something odd is here.
We said this is three-year depreciation but there are four years here. And the reason for that is that they use a half-year convention, which means that the first year is assumed that you put the property into use on July 1st, the middle of the year. So you only get a half a year's depreciation there. and in the final year you get another half year. So this is full year, full year, and these two are half year, and that adds up to three years.
So you know, same thing with the five year. There are six years here, even though it's a five year schedule. For the seven year, there are eight periods, or eight years, even though it's a seven year depreciation schedule for that half year convention.
Alright, let's take a look at an example. Suppose you have a piece of equipment that costs a million dollars and has a salvage value of $200,000. Let's find the depreciation each year, assuming the equipment has a useful life of five years. Let's also compute the book value for each year and the after-tax salvage value if you sell the equipment in year three for $425,000. And let's assume that the tax rate is 35%.
So I've recreated that five-year schedule here, and what you're going to do is you're going to take 20% of the million-dollar cost of the equipment, which is $200,000. Again, you don't subtract out the salvage value, in which case this would be a smaller depreciation amount. You take the $200,000 that's depreciated from the original book value, which was $1 million, and you have an $800,000.
thousand dollar book value in year one. In year two, 32% of the million is $320,000. So these percentages are always times the original cost. That's $320,000.
Subtract that from the new book value, which was $800,000, you have a book value of $480,000, etc., etc. Notice that it depreciates it to zero. If you were to have subtracted out... the salvage value, you would find that you would only depreciate it down to that salvage value that we had listed. Okay, so we said let's also calculate the after-tax salvage value or the after-tax cash flow if you sell this piece of equipment for $425,000 in year three.
Now, You're going to sell it for $425,000, but there's a tax consequence. The tax consequence is you're going to have possibly a capital gain or a capital loss. What does that mean?
That means that you're selling it for more or less than it's worth. In this case, The book value is $288,000, but you're selling it for $425,000. So you have a capital gain here, and you're going to be taxed on that, and we assume the tax rate was 35%. Now, again, a common mistake that's made is people think that you get taxed on the full $425,000. That's not correct.
You get taxed on the amount. of the capital gain how much you're selling it for above the book value so in this case you're going to pay uh forty seven thousand nine hundred and fifty dollars in taxes and so your after tax salvage value your after tax cash flow is going to be three hundred and seventy seven thousand and fifty dollars okay so if you're doing some sort of analysis where you're looking at the cash flow um from selling this it's going to be $377,050. All right, let's take a look at one other example.
Suppose you can only sell the equipment for $200,000. Okay, the book value is $288,000. You're actually selling, you have a capital loss. Well, it turns out that you're going to have some tax savings here of $30,800. Okay, you're going to have an $88,000 capital loss times 35%.
So you're going to save $30,800 in taxes. So your cash flow is going to be $230,800. All right, to summarize, the MACRS allows firms to recover the cost of new equipment faster than the straight line method.
And again, the logic for that is that if the firm can get their money back faster, they can reinvest. in new equipment, new plants, create jobs, etc. The IRS specifies the useful life of the different types of equipment and they also provide the schedules based on those useful lives. And as I mentioned before, the MACRS uses this half-year convention which assumes that the equipment is acquired on July 1st, therefore the first and the last year use half the depreciation. So it's only half a year's worth of depreciation.
For example, again, the three-year useful life will be depreciated over four years. So this is a useful depreciation method to know if you're doing analysis. This is the method you should use because this is the actual schedule that the IRS provides and that you use when you're doing your taxes.