Depreciation occurs over the useful life of equipment and many improvements. With proper planning and documentation, owners of business and investment-related real estate can maximize tax benefits by claiming depreciation on allowable land improvements. Understanding what types of improvements are eligible for depreciation will help people better plan for tax time.
Depreciation refers to "the allocation of an asset's cost to the accounting periods benefited," says Larry Walther, Ph.D., CPA, CMA. Allocate cost based on the service life of the improvement and certain maintenance and repair costs. Taxpayers may depreciate certain improvements to owned land, but not the land itself.
Do not depreciate the costs of acquiring land, such as surveys and fees. Neither should land owners depreciate land improvements which add to the value of the land for non-specific use, such as grading the property to level it or laying out roads and road beds. The costs of such improvements increase the basis in the property rather than depreciate.
Do depreciate improvements which are use-specific, such as a temporary road to a worksite or grading for a golf course, or will wear out over time and require replacement, such as a road surface. Investigate the possibilities of depreciating the cost of an improvement when the use will likely be changed if the property is sold. For instance, installing a walk-in cooler in retail space used as a delicatessen which may be converted by a future owner to dry goods sales or a book store may be depreciable. Deduct any salvage value on the improvement before calculating depreciation.
The Modified Accelerated Cost Recovery (MACRS) applies to improvements placed in service after 1987 and is the method most taxpayers must use, according to IRS. Using the basis of the improvement, the class life of the improvement and the MACRS tables in IRS publication 946, calculate the allowable depreciation on the improvement.
Accounting methods employed to depreciate improvements offer more choices than for tax reporting. Dr. Walther identifies the most popular methods as straight-line, calculated by taking the value of the improvement, minus any salvage value (the basis), divided by the estimated years of service; units-of-output-calculated on the basis on estimated usage over the expected years of service; double-declining-balance-an calculation which accelerates the amount of depreciation in the early years of the improvement; and sum-of-the-years'-digits, a formula based on a fraction derived from the actual year of service divided by the total expected number of years of service.
Depreciation calculations for land improvements begin with estimates of expected years of service. Adjust estimations when necessary for more accurate calculations.
Calculations for tax purposes benefit from "incentive" programs passed by the federal government in response to market conditions. Stay up-to-date on tax decisions to get the highest allowable deduction. Correct any earlier errors by filing an amended return.
Consult a tax attorney or Certified Public Accountant for recommendations in specific situations. General descriptions cannot replace expert advice.