Tax depreciation is the way in which a tax system takes account of depreciation. This is the decline in value of an asset over time. The most common variant of tax depreciation involves splitting the purchase price over a set number of years. Each year's portion of the price can then be classed as an expense, thus lowering a company's taxable income.
Depreciation is the concept of assets losing value. This can involve both the usefulness of an asset to a company and the asset's resale value. Usually, both will apply to the same asset, but in different proportions. For example, the main depreciation concern with a machine is that it will eventually wear out and be of no use. For a delivery firm, however, the main concern is that a van will not make its purchase price back as and when it is sold on the second-hand market.
In financial terms, a company that owns assets will effectively lose money over time. Tax depreciation is a way of recognizing these losses when calculating the tax a business must pay on its profits. In most countries, most or all of the value of an asset can eventually be set off against income for tax purposes. The main difference between countries is the timescale.
The United States uses a tax depreciation system known as the Modified Accelerated Cost Recovery System of MACRS. This system involves the IRS designating a "life" for each type of asset. This life is the duration that affects calculations of the annual amount listed as depreciation for tax purposes.
The most significant aspects of MACRS is that it is an accelerated tax depreciation scheme. This means the designated life of an asset will often be shorter than the actual period of when it is still useful to the company. The result is that the company can claim a larger proportion of the asset's value as a tax deduction in the first few years after buying it. Though this lowers overall tax revenues, economists supporting the system argue that it gives companies incentives to invest in assets, thus boosting the overall economy.
Companies covered by MACRS do not simply divide the asset's value by the number of years in its designated "life." Instead, the business must follow a set table of the deduction each year. For example, with an asset with a designated life of three years, the deductible amount is 33.33% of the purchase price in the first year, 44.45% in the second year, 14.81% in year three and 7.41% in year four. The reason the deductions are carried out over four years and the first year is not the greatest reduction is to take account of the fact that businesses usually purchase, and begin benefiting from, an asset part of the way through a financial year.