Identifying and Correcting Common Depreciation Problems

Depreciation is an accounting process for allocating a tangible asset’s cost over its period of use. This process appears on financial statements to align expenses with revenues and on tax returns as a deduction that lowers taxable income. The detailed requirements for calculating this deduction create common points for error. Uncorrected mistakes can lead to inaccurate financial reports, incorrect tax payments, and issues with the Internal Revenue Service (IRS).

Foundational Calculation Errors

The starting point for depreciation is the asset’s cost basis, and errors here invalidate all subsequent figures. An asset’s basis includes its purchase price plus all costs necessary to place it in service, such as sales tax, freight, and installation fees. A frequent mistake is expensing these associated costs immediately instead of adding them to the asset’s basis, which reduces the amount available for depreciation.

A period for depreciation must also be determined. For financial reporting, this is the asset’s “useful life,” an estimate of how long it will provide economic benefit. Tax depreciation uses a “recovery period” set by law. The IRS provides specific recovery periods for different classes of assets under the Modified Accelerated Cost Recovery System (MACRS), such as five years for computers and seven years for office furniture. Applying an incorrect recovery period misstates the annual tax deduction.

Another element is the asset’s salvage value, its estimated worth at the end of its service life. The treatment of salvage value marks a divergence between financial and tax accounting. For financial statements, the depreciable basis is the cost basis minus the salvage value. For tax purposes under MACRS, salvage value is disregarded and treated as zero. A common error is subtracting salvage value when calculating the MACRS tax deduction, which results in an underclaimed depreciation expense.

Incorrect Application of Depreciation Methods and Conventions

Errors can also occur when applying the depreciation method and its conventions. For financial reporting, a business may select from several methods, like the straight-line or accelerated methods. For tax purposes, the choice is restricted, as the IRS mandates MACRS for most tangible property placed in service after 1986.

The MACRS framework includes timing rules called conventions, which determine the deduction for the year an asset is placed in service and disposed of. The default is the half-year convention, which treats all property acquired during a year as placed in service mid-year, allowing for a half-year of depreciation. This convention applies unless specific circumstances trigger a different rule.

A common error is failing to apply the mid-quarter convention when required. This convention is triggered if the total cost basis of property placed in service during the final three months of the tax year exceeds 40% of the total basis of all property placed in service for the entire year. This rule requires depreciating all personal property placed in service during that year from the midpoint of the quarter in which it was acquired.

For example, if a business buys $100,000 of equipment in a year, with $50,000 of it purchased in the final quarter, the 40% threshold is met ($50,000 is 50% of $100,000). Consequently, the business cannot use the standard half-year convention. It must instead group all assets by the quarter they were placed in service and calculate depreciation from the midpoint of that quarter.

A separate rule, the mid-month convention, is required for residential rental and nonresidential real property. This convention treats such assets as placed in service in the middle of the month of acquisition.

Issues with Asset Disposals and Recapture

Problems also arise when an asset is sold or retired. The taxable gain or loss is the asset’s sale price minus its adjusted basis. The adjusted basis is the original cost basis less all accumulated depreciation. A common mistake is subtracting the original cost from the sale price, which ignores accumulated depreciation and leads to an understated gain or an overstated loss.

Depreciation recapture is a tax rule that can recharacterize how a gain is taxed. When a business asset is sold for a profit, the gain is not automatically treated as a long-term capital gain. The tax code requires the portion of the gain from previous depreciation deductions to be “recaptured” and taxed at ordinary income rates, which are often higher than capital gains rates. This prevents businesses from converting ordinary income into lower-taxed capital gains.

The recapture rules depend on the property type. For personal property like equipment and vehicles, Section 1245 governs, treating any gain on the sale as ordinary income up to the amount of depreciation claimed. For real property, Section 1250 applies, where the “unrecaptured Section 1250 gain” is the portion of the gain from depreciation taxed at a maximum rate of 25%, a rate higher than typical long-term capital gains rates for many taxpayers.

Correcting Depreciation Errors from Prior Years

Discovering a depreciation error from a prior tax year requires a specific correction process. A taxpayer cannot file an amended tax return (Form 1040-X or 1120-X) to fix this type of mistake. The IRS considers using an incorrect depreciation calculation to be an improper method of accounting, and correcting it requires a formal change in accounting method.

This change requires filing IRS Form 3115, Application for Change in Accounting Method. To complete this form, a taxpayer must provide:

• The business’s identifying information
• A detailed description of the property with the incorrect depreciation
• A statement of the incorrect accounting method used
• A statement of the correct method that will be adopted

The form also requires calculating the Section 481(a) adjustment. This is the cumulative difference between the depreciation taken under the incorrect method and what should have been taken under the correct method up to the beginning of the year of change.

Filing Form 3115 involves a two-part process. An original, signed form is attached to the taxpayer’s timely filed federal income tax return for the year of the change. For most depreciation corrections, a signed copy must also be mailed to the IRS national office. The Section 481(a) adjustment is then reported on the tax return for the year of the change, either increasing or decreasing taxable income to correct the lifetime depreciation amount.