Accelerated Depreciation Definition
Accelerated depreciation benefits real estate investors who have high initial costs and low residual value because the amount being depreciated is higher during the first few years of owning a property.
How Does Accelerated Depreciation Work?
Under accelerated depreciation, an asset’s value is spread over its useful life.
For example, let’s say you buy a new asset for $100k and it has a useful life of 5 years. Instead of depreciating the whole value at once, you would only depreciate $20k each year ($100k/5 years).
Accelerated depreciation benefits real estate investors because it will lower the taxable amount on their income each year, as well as save them money on taxes.
Types of Accelerated Depreciation
There are several types of accelerated depreciation, including Sum-of-the-Years’-Digits (SYD), Declining Balance, Units of Production, and Modified Accelerated Cost Recovery System (MACRS)
SYD is an accelerated method that is used with the straight-line depreciation formula.
This depreciation method is used to frequently reduce the value of an asset throughout its useful life.
This works by taking the total cost of all assets and dividing it by their useful life, then multiplying this number by each year’s benefits amount.
For example, if there are 5 assets in your possession with a useful life of 3 years. Their cost is $50,000 each and they have a total useful life of 15 years. Their benefits would be:
($50,000 x 3) = $150,000, then ($150,000/15 years) = $10k benefits per year.
Under the Declining Balance method of depreciation, benefits are higher in the beginning of an asset’s useful life and then decrease over time.
For example, if you have $90,000 to depreciate over 5 years using the Declining Balance method, benefits would be:
Year 1: $90,000/5 = $18k in benefits
Year 2: (90,000 – 18,000) / 5 = $9,800 in benefits
The decrease of benefits is the reason why the Declining Balance method is also called Accelerated Declining Balance.
Units of Production:
Under Units of Production depreciation, benefits increase as an asset is used more and its useful life is shortened.
For example, if there is a machine that costs $100,000 and it can be used to produce 2 units of product per month for 5 years.
Then the unit cost would be: ($100,000/2 units) = $50k per unit or (50k x 12 months) = $600k total products produced over the life of the machine.
The benefits of the machine would be: ($600,000) /5 years) = $120k per year (for 5 years).
Modified Accelerated Cost Recovery System (MACRS):
MACRS benefits are similar to the sum-of-the-years’-digits method, which benefits businesses that have many different assets or depreciate multiple assets over the same period.
This method benefits real estate investors because it spreads the total cost of an asset over a longer period, which benefits those who have a limited cash flow.
This method allows you to use accelerated benefits if you own between 5-20 depreciable assets, depending on your type of profession.
How to Calculate Accelerated Depreciation
To calculate the accelerated depreciation of an asset, you will need to find two figures:
– The recoverable amount (cost minus salvage value)
– The useful life of the asset in years
- First, subtract your salvage value from your cost. If your salvage value is greater than what you paid for it, then the first year’s depreciation is a negative number.
- Divide your first year’s depreciation by the useful life of the asset in years. This will give you a decimal between 0 and 1.
- Multiply that decimal value by 100%. This is the first-year accelerated depreciation percentage for your asset.
- Repeat Steps 2 and 3 for as many years as you can depreciate the asset.
- Add up all of these percentages and subtract them from 100 to find the total accelerated depreciation.
- Subtract your salvage value from your recoverable amount
- Find the written down the value by multiplying the remaining balance by .035 if using straight-line depreciation or .27 if using MACRS depreciation.
What are the Benefits and Drawbacks of Accelerated Depreciation?
The benefits of accelerated depreciation are that you can decrease your taxable income and you can also increase your net cash flow.
Accelerated depreciation benefits real estate investors because it allows them to depreciate their purchase price more quickly, which decreases the net taxable income on their taxes and also increases their cash flow.
The drawback of accelerated depreciation is that it decreases the value of an asset faster than its actual use or wear and tear would require you to.
The benefits of not using accelerated depreciation for real estate investors are that the value of the asset will be lower over its useful life, which means a lower purchase price.
Examples of How to Use Accelerated Depreciation
An example of how to use accelerated depreciation is when purchasing a new property for a business.
The benefits and drawbacks of accelerated depreciation for a business is that the value will be depreciated at a faster rate, which will decrease your net taxable income.
The benefits and drawbacks of not using accelerated depreciation for a business are that the value will not be depreciated as fast, which means a higher purchase price.
Limitations of Using Accelerated Depreciation
One of the limitations of using accelerated depreciation is that it will decrease the value of the asset faster than its actual use or wear and tear would require you to.
Another limitation of using accelerated depreciation for business investment is that if your business makes less money in some years, you may not be able to depreciate some purchases at all.
Final Thoughts on Accelerated Depreciation
Real estate investors should always consider using accelerated depreciation benefits when looking at assets to purchase or acquire.
This benefits real estate investors because it will lower the taxable amount on their income each year, as well as save them money on taxes.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.