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When tax time rolls around, you have to calculate all of your business expenses, including those revolving around your assets. For certain assets, the IRS requires you to use an alternative depreciation system (ADS) to determine how much of an asset’s cost you can write-off each year. You also have the option of using the ADS method of depreciation for any asset your business purchases.ADS generally increases the number of years over which an asset is depreciated. This decreases the size of the deduction you can take each year, but allows you to deduct depreciation expenses for a longer period of time.Learn which assets require using the ADS method, how to use ADS to calculate depreciation, and when you may be better off using a declining balance deduction method (known as GDS) instead of ADS.
ADS DefinedWhat is depreciation and ADS depreciation in particular? Depreciation is a method used in business accounting that allows businesses to write off the cost of a physical asset over a specified number of years, which is known as the useful life of the asset. Businesses can depreciate many kinds of assets, including computers, office furniture, fixtures, vehicles, and manufacturing equipment.There are two main depreciation systems allowed by the IRS: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS is more commonly used, but for some assets ADS needs to be used. For the most part, the ADS system increases an asset's useful lifespan and, thus, the number of years it can be depreciated. This reduces depreciation expenses each year, but extends the number of years that a business can deduct depreciation expenses for that asset.ADS calculates depreciation using a straight-line method, which divides the difference between the asset's cost and expected value after use (known as its salvage value) by the number of years it's expected to be used. The depreciation amount is the same each year.Recommended: What Are Common Small Business Loan Terms?
How an Alternative Depreciation System WorksOne key benefit of the ADS method is that it’s simple to calculate. Here’s how.
How to Calculate ADSFirst, you need to determine the useful lifespan of the asset you are depreciating. To do this, refer to the IRS’s ADS depreciation table. Agriculture equipment, for example, has a useful life of 10 years under the ADS method, which means the IRS estimates that you will get 10 years of use out of the equipment before you should sell and replace it. In addition, you’ll need to approximate the item’s salvage value, which is how much you could sell the asset for after its useful lifespan.Next, you can calculate its depreciation using the straight-line method. The formula:(Cost of asset — salvage value)/ useful lifeExample 1: You buy a tractor for $50,000. It has a useful life of 10 years. After 10 years, you determine that you’ll be able to sell it for $5,000. =($50,000 - $5,000) / 10 years=$45,000 / 10=$4,500In this scenario, $4,500 is the amount you’ll be able to deduct each year for 10 years as a business expense. After 10 years, you’ll have deducted $45,000, at which point you will no longer be able to claim any depreciation expenses from the tractor. Should you sell your tractor for more than $5,000 after 10 years, any additional amount over $5,000 will have to be claimed as income and will be taxed accordingly by the IRS. Example 2: You purchase a new laptop for your business and spend $3,000. It has a useful life of five years and an expected salvage value of $500.=($3,000 - $500) / 5 years=$2,500 / 5 years=$500In this example, you’ll be able to deduct $500 a year for five years as a business expense due to depreciation. Should you sell the computer for more than $500, the extra amount should be included as income.
Who Uses ADS?Business owners often don’t choose ADS, and instead opt for GDS (which allows you to depreciate more of an asset's value in the earlier years of its life). However, there are some assets where you have to use ADS. Those assets include:
Farming assets and residential rental properties outside of the U.S. are particularly singled out. If you have recently entered the farming industry or purchased rental real estate, ADS is in your future. Many people who truly understand tax laws see the ADS depreciation residential rental property recovery period as too long, and think twice before purchasing property in another country. The laws regarding when you are required to use ADS and when you have a choice can be complex. It can be a good idea to consult a CPA or other tax professional to determine which depreciation method you should use for your business assets. Sometimes you don’t have a choice, but when you do, you may find that GDS is preferable because of the shorter recovery periods.If you use ADS, just know that you typically can’t switch to another system once you start. If you purchase multiple assets the same year that are in the same class (for example, everything is considered agricultural machinery), you generally must use the same depreciation method for each asset. You can’t pick and choose which method to use for each.
- Farming equipment
- Property used primarily for farming
- Tax-exempt use properties
- Tax-exempt bond-financed property
- Tangible property used outside of the US (which includes real estate)
- Property used for 50% or less for business
How ADS Depreciation Affects TaxesA company's depreciation expenses reduce the amount of taxable earnings, thus reducing the taxes owed. The larger the depreciation expense, the lower the taxable income, and the lower a company's tax bill. The smaller the depreciation expense, the higher the taxable income and the higher the tax payments owed.The GDS depreciation method allows companies to accelerate the asset's depreciation rate by recording a larger depreciation amount during the early years of an asset's useful life and smaller amounts in later years. With ADS, however, you depreciate an asset in equal amounts over a longer period of time. As a result, the yearly deductions for depreciation are typically smaller than with the GDS method, which could increase your taxable income and how much tax you owe.
Pros and Cons of an Alternative Depreciation SystemThere are both advantages and disadvantages of using an ADS method of depreciation. Here’s how they stack up.
ProsADS allows your business to extend the number of years you can depreciate an asset, thus giving you a way to reduce taxable income for a longer period of time. What’s more, in many cases, the ADS’s extended deprecation schedule may better mirror an asset’s actual useful life and income-producing abilities than the GDS method. Another plus of the ADS method is that it’s simple to calculate. In addition, it provides consistent deductions year to year for the entire recovery period, which can make calculating small business cash flow easier.
ConsOn the downside, ADS decreases the amount you can write off each year. And, unlike the GDS depreciation method, you can’t take a larger deduction (called a bonus deduction) the first year. In addition, once you choose the ADS method, you not only have to stick with it for the lifespan of the asset, but you also have to stick with it for any other property or assets in the same class that you purchase in the same year.
|Pros of ADS||Cons of ADS|
|Extends the number of years you can depreciate an asset||Decreases the amount you can write off each year|
|May better mirror an asset’s actual useful life||No bonus deduction in the first year|
|Simple to calculate||Once you choose ADS, you cannot switch to a different depreciation method|
ADS vs. GDS One of the major differences between ADS and GDS is that ADS offers depreciation over a longer period of time than GDS (see table below). Another key distinction is that ADS only allows the straight-line method for calculating depreciation. By contrast, GDS allows for three different depreciation methods:
Because GDS allows for declining balance methods, it’s often used by companies to depreciate assets that tend to become obsolete quickly and are replaced with newer versions on a fairly frequent basis, such as computers and phone equipment.GDS also allows for bonus depreciation, which enables companies to deduct a large percentage of the purchase price the first year. ADS doesn’t allow this.Here’s a look at the differences in recovery periods (or useful life) allowed by ADS vs GDS.
- The straight-line method
- The 200% declining balance method
- The 150% declining balance method
For the most part, ADS recovery periods are longer than GDS’s — with cars and computers being the only two that are the same in both depreciation methods.
|Asset||ADS Recovery Period (in years)||GDS Recovery Period (in years)|
|Agricultural equipment and machinery||10||5 or 7|
|Computers and computer equipment||5||5|
|Fruit bearing trees or vines||20||10|
|Nonresidential real estate||40||39|
|Office equipment and furniture||10||7|
|Qualified Improvement Property||20||15|
|Residential rental property producing income after 12/31/2017||30||27.5|
|Residential rental property producing income before 1/1/2018||40||27.5|
The TakeawayThe IRS allows two different methods to depreciate business assets: the general depreciation system (GDS) and the alternative depreciation system (ADS).GDS allows companies to accelerate the asset's depreciation rate by recording a larger depreciation amount during the early years of an asset's useful life and smaller amounts in later years. ADS uses a straight-line method where deduction amounts are the same each year. Since ADS offers depreciation over a longer course of time, the yearly deductions for depreciation are smaller. GDS is more commonly used than ADS, but certain situations require ADS.The tax implications of calculating depreciation can affect a company's profitability. For this reason, business owners need to carefully consider the pros and cons of ADS vs GDS.
3 Small Business Loan Tips
- If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.
- SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.
- If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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About the Author
Lauren WardLauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.