What is the Difference Between Book Depreciation and Tax Depreciation?
What is depreciation?
Depreciation acknowledges the normal wear and tear that occurs from the usage of the building. Depreciation allows the owner to take a tax deduction based on the reduction in value of the building because of the wear and tear.
Depreciation is considered a non-cash expense, indicating that no actual money is spent to generate this deduction. In contrast, a cash expense involves the outlay of money, such as expenditures on rent, utilities, property taxes, payroll, and maintenance. Depreciation, governed by accounting principles and standards like GAAP or IFRS, is recorded as an expense on the income statement. This accounting practice decreases the net income reported by a company, which in turn reduces the amount of tax owed.
What is book depreciation?
Book depreciation is the amount recorded in a business’s financial statement for a fixed asset (in our case, the asset will be a building or rental property) that is allocated over the useful life of that asset. The useful life of an asset has a very specific class life set by the IRS. A residential rental property or multi-family property has a class life of 27.4 years. A commercial building has a class life of 39 years. Typically, a CPA will use the longest possible class life for the asset because it increases the profitability on the owner’s financial statements.
What is tax depreciation?
Tax depreciation is a depreciation expense taken by an owner on their tax return for a given tax period. Tax depreciation is very advantageous because it allows building owners to reduce their taxable income as much as possible, which reduces the tax owed. Typically, CPAS will take a much more aggressive stance on depreciation by doing a cost segregation study or taking bonus depreciation, both of which will reduce the owner’s tax liability.
According to the IRS guidelines, an asset must meet specific criteria to qualify for depreciation:
- It must be property the business client owns.
- It must be used in a business or income-producing activity.
- The asset must have a determinable useful life.
- The asset must be expected to last more than one year.
What distinguishes book depreciation from tax depreciation?
While depreciation can apply to both book and tax, there are differences between book and tax depreciation. Book depreciation is documented as a depreciation expense on the income statement. Tax depreciation is an actual tax deduction listed on the tax return that reduces the owner’s taxable income.
There are hard rules that allow for tax depreciation. The asset’s functional, useful life, and actual usage are not taken into consideration. The only thing that matters is the class life of the asset set by the IRS.
Book depreciation more accurately reflects the actual usage of an asset over time. There are notable differences in how tax depreciation and book depreciation are calculated. For book depreciation, the straight-line method is commonly employed, which involves dividing the cost of the asset by its IRS-specified class life to determine the annual depreciation expense.
In contrast, tax depreciation utilizes a method known as the Modified Accelerated Cost Recovery System (MACRS). This approach allows for a quicker recognition of depreciation expense compared to the straight-line method. Additionally, a cost segregation study can further accelerate the depreciation expense, leading to even faster tax deductions.
What is book-to-tax reconciliation?
Book-to-tax reconciliation is the reconciliation of net income reported for book to the net income reported for tax. This process uses Schedules M-1 and M-2 to reconcile the accounting income to match the taxable income. For companies with assets exceeding $10 million, Schedule M-3 is required, providing a more comprehensive level of detail.