The straight-line depreciation method is a common way of allocating “wear and tear” to the cost of an item over its lifespan.
This method assumes that an asset declines in value by the same amount each year, or that it has no salvage value.
The depreciation of an asset under the straight-line depreciation method is constant per year.
How Does It Work?
To use straight-line depreciation, determine the expected economic life of an asset.Divide the number 1 by the number of years in the expected economic life.
This gives you a straight-line depreciation rate.For instance, if an asset has a five-year life, 1 ÷ 5 = 0.2, or 20%.Then, multiply the original cost of the asset by the straight-line depreciation rate to find annual depreciation.
Continuing with the previous example, if the asset costs $10,000, then 1.20 x $10,000 = $1,200 per year.
This method is useful because it allows you to determine your annual depreciation at the beginning of the year and know how much this will affect net income or loss.
Why Would You Choose This Method?
Straight-line depreciation is an easier method than other depreciation methods because it requires less record-keeping and calculation.
It allows you to calculate your yearly tax obligation based on the cost, residual value, number of years that you expect to use the asset, and rate of straight-line depreciation.
This method is most appropriate when you want to allocate the cost of an asset evenly over its useful life, without taking into account any additional factors.
When Should You Use This Method?
If you are unsure of how long you will use an asset or think that it will not be used very intensely (like a copier machine), then this method is appropriate.
This method is also useful if you know that an asset will be sold at the end of its life and any cash proceeds will be used to purchase a replacement.
You would use straight-line depreciation during the time that you own the asset and take a deduction for this portion of the total cost, and then switch to MACRS depreciation when you sell the asset.
Finally, this method is also useful when an asset has only one individual in mind to use it.This may be your car or a piece of machinery that is used by only one person in your business.
Why Would You Not Choose This Method?
Straight-line depreciation does not take into account that a major expense of an asset, such as a car or truck, is the frequency at which you use it.
This means that it will likely underestimate the cost of owning and using this type of asset.Straight-line depreciation does not allow for accelerated tax savings, since the deduction occurs on an equal basis each year.
You would not use this method if you expect to depreciate an asset much more quickly than the average rate of straight-line depreciation, for example, a computer that is expected to quickly become obsolete.
Finally, this depreciation method is not appropriate and should not be used when an asset has a shorter expected economic life than the tax life of the asset, which is typically 7 years.
Other Types of Depreciation Methods
High-Low Method
The high-low method is a simplified version of the double-declining balance method.
This is another accelerated depreciation method, and it is most appropriate when an asset will be used intensely for several years and then experience a decrease in use (such as a machine that would be used intensely during its first few years of operation).
Declining Balance Method
The declining balance method is another accelerated depreciation method that is based on the double-declining balance formula.
This method is more appropriate than straight-line depreciation when an asset is used intensely and its production capacity decreases over time, such as a machine that will become less productive after several years of operation.
Sum-of-the-Years’ Digits Method
The sum-of-the-years’ digits method is another accelerated depreciation method that takes into account the increasing cost of an asset as it wears down or becomes obsolete.
ACRS (Modified Accelerated Cost Recovery System)
The ACRS provides a faster depreciation schedule for large capital expenditures, but it has been repealed and replaced by MACRS.
MACRS (Modified Accelerated Cost Recovery System)
The Modified Accelerated Cost Recovery System is the current depreciation schedule for assets placed in service after 1986.
MACRS depreciation is the only accelerated depreciation technique allowed for tax purposes and it requires more documentation than other methods.
It also has a higher cost because you must pay 1/2 of 1% of your basis in the asset each quarter.
150% Declining Balance Method
The 150% declining balance method is an accelerated depreciation method that uses 1/2 of 1/3 of the total basis as 1 year’s worth of depreciation, which reduces your deduction at a faster rate than MACRS.
This is another form of accelerated depreciation, and it can be used with any depreciation method.
Final Thoughts
Depreciation methods come in many forms and should be utilized according to the information you have about your asset and how it will be used.
No single depreciation method is perfect, but each one has its own set of benefits and limitations.
Depreciation schedules can be complicated and you should seek the advice of a tax professional if needed, but these methods will provide you with a better understanding of how to calculate depreciation for your assets.
Straight-line depreciation is a very useful method that allows one to depreciate an asset evenly over time at a set rate.
In other words, it is a systematic way of calculating depreciation deductions in equal amounts for each unit of the asset during its useful life.
You can use this method when you know how long an asset will be in service and what the salvage value will be at the end of that service period.
The straight-line depreciation method is not appropriate for assets with a useful life of less than 1 year or when you expect to use an asset more intensely during the first few years of its useful life and then reduce its use over time.
This method is also not appropriate if the salvage value varies over time.
