Contractors own expensive equipment, and depreciation is how that cost is spread over the years the equipment is used. The B&F outline touches depreciation in several places: acquiring fixed assets and lease vs. purchase (Area A), equipment decisions (Area C), and job cost and tax accounting (Area D). Questions are usually arithmetic. Know three methods well: straight-line, double declining balance, and the IRS MACRS tables.
Vocabulary first
| Term | Meaning |
|---|---|
| Cost (basis) | What you paid, including costs to put the asset in service |
| Salvage value | Estimated value at the end of its useful life |
| Useful life | Years (or hours, or units) you expect to use it |
| Depreciable base | Cost minus salvage (for straight-line and units of production) |
| Accumulated depreciation | Total depreciation taken so far |
| Book value | Cost minus accumulated depreciation |
Land is never depreciated. If you buy a building, only the building portion is depreciable.
Running example
A contractor buys an excavator for $120,000. Estimated salvage value is $20,000. Useful life is 5 years.
Method 1: Straight-line
Equal depreciation every year.
Annual depreciation = (cost − salvage) ÷ life
($120,000 − $20,000) ÷ 5 = $20,000 per year
| Year | Depreciation | Accumulated | Book value (end of year) |
|---|---|---|---|
| 1 | $20,000 | $20,000 | $100,000 |
| 2 | $20,000 | $40,000 | $80,000 |
| 3 | $20,000 | $60,000 | $60,000 |
| 4 | $20,000 | $80,000 | $40,000 |
| 5 | $20,000 | $100,000 | $20,000 |
Book value ends at salvage. A typical question asks for book value at the end of some year: cost minus (annual depreciation × years). After 3 years: $120,000 − $60,000 = $60,000.
Method 2: Double declining balance (DDB)
An accelerated method: more depreciation early, less later.
Rate = 2 ÷ life. For 5 years, 2 ÷ 5 = 40%.
Each year: depreciation = beginning book value × rate. Salvage is not subtracted when applying the rate, but book value may not go below salvage.
| Year | Beginning book value | × 40% | Depreciation taken | Ending book value |
|---|---|---|---|---|
| 1 | $120,000 | $48,000 | $48,000 | $72,000 |
| 2 | $72,000 | $28,800 | $28,800 | $43,200 |
| 3 | $43,200 | $17,280 | $17,280 | $25,920 |
| 4 | $25,920 | $10,368 | $5,920 (limited) | $20,000 |
| 5 | $20,000 | $0 | $20,000 |
In year 4, a full 40% would push book value to $15,552, below the $20,000 salvage value, so depreciation stops at $5,920. Total depreciation is still $100,000, the same as straight-line. Only the timing differs.
Common errors: subtracting salvage before applying the rate in year 1 ($100,000 × 40% = $40,000 is wrong for DDB), and applying 40% to original cost every year instead of to the declining book value.
A 150% declining balance method works the same way with a rate of 1.5 ÷ life.
Method 3: Units of production
Depreciation follows usage instead of time.
Rate per unit = (cost − salvage) ÷ total expected units
If the excavator is expected to run 10,000 hours: $100,000 ÷ 10,000 = $10 per hour. A year with 1,800 hours gives 1,800 × $10 = $18,000.
MACRS: the tax method
For federal income tax, most business equipment placed in service after 1986 is depreciated under the Modified Accelerated Cost Recovery System (MACRS), described in IRS Publication 946. MACRS differs from book methods in three important ways:
- Salvage value is ignored. You recover the full basis.
- The recovery period is set by property class, not by your estimate of useful life.
- Conventions decide how much you get in the first year.
Property classes you should know (GDS)
| Class | Examples from Publication 946 |
|---|---|
| 5-year | Automobiles, taxis, buses and trucks; office machinery such as calculators and copiers |
| 7-year | Office furniture and fixtures (desks, files, safes); property with no assigned class life |
| 27.5-year | Residential rental property |
| 39-year | Nonresidential real property (for example, an office or shop building) |
Conventions
- Half-year convention: all personal property placed in service during the year is treated as placed in service at the midpoint, so you get half a year of depreciation in the first year no matter which month you bought it.
- Mid-quarter convention: required instead if more than 40% of the depreciable basis of property placed in service during the year (not counting real property and certain other items) was placed in service in the last three months of the year.
- Mid-month convention: used for residential rental and nonresidential real property.
The 5-year table
Under the half-year convention, 5-year property using 200% declining balance is recovered over six tax years because of the half year at each end. Publication 946 shows these percentages, applied to the original basis every year:
| Year | Rate | Excavator ($120,000) |
|---|---|---|
| 1 | 20.00% | $24,000 |
| 2 | 32.00% | $38,400 |
| 3 | 19.20% | $23,040 |
| 4 | 11.52% | $13,824 |
| 5 | 11.52% | $13,824 |
| 6 | 5.76% | $6,912 |
| Total | 100% | $120,000 |
Notice the whole $120,000 is deducted. The $20,000 salvage value plays no part for MACRS.
(For exam purposes, treat the excavator as 5-year property as the question states. The actual MACRS class for a given piece of equipment depends on its asset class in Publication 946.)
Section 179 expensing and bonus (special) depreciation can let a business deduct much more in the first year. Their dollar limits and percentages change by tax year, so check the current Publication 946 rather than memorizing a figure.
Book vs. tax side by side (excavator, years 1 to 3)
| Year | Straight-line | DDB | MACRS 5-year |
|---|---|---|---|
| 1 | $20,000 | $48,000 | $24,000 |
| 2 | $20,000 | $28,800 | $38,400 |
| 3 | $20,000 | $17,280 | $23,040 |
Many contractors keep one set of numbers for financial statements and another for taxes. That is normal and legal.
Depreciation and cash
Depreciation is an expense that does not use cash in the current period. On an indirect-method cash flow statement it is added back to net income. That is also why financial ratios and cash flow can tell a different story from net income.
Depreciation in the bid
Equipment ownership cost (depreciation, interest, insurance, taxes) is part of what a contractor must recover through its rates. Comparing that annual ownership cost with rental cost is the core of a lease vs. purchase question. See job costing and estimating and time value of money.
Practice depreciation math
Our Florida Business and Finance Exam Prep includes original depreciation questions covering all three methods and the MACRS tables, with full worked solutions and 90 days of practice. See also the B&F exam overview.
Practice questions
A contractor can buy a truck for $48,000. It has an estimated 6-year life and an $6,000 salvage value. What is annual straight-line depreciation?
- A$8,000
- B$6,000
- C$9,000
- D$7,000
Show answer
Answer: D. Straight-line = (cost - salvage) ÷ life = ($48,000 - $6,000) ÷ 6 = $7,000 per year. $8,000 comes from ignoring salvage value.
Source: Straight-line depreciation
A $100,000 truck has a 5-year life and $10,000 salvage. Under double-declining-balance (book), depreciation in year 2 is:
- A$40,000
- B$18,000
- C$24,000
- D$36,000
Show answer
Answer: C. DDB rate = 2/5 = 40%. Year 1: $100,000 x 40% = $40,000 (book value $60,000). Year 2: $60,000 x 40% = $24,000. Salvage is not subtracted when applying the DDB rate.
Source: Standard accounting/construction-management principle
A truck cost $90,000, has a $6,000 salvage value, and a 7-year life (straight-line). What is its book value at the end of Year 3?
- A$51,429
- B$36,000
- C$54,000
- D$48,000
Show answer
Answer: C. Annual depreciation = ($90,000 − $6,000) / 7 = $12,000. Accumulated after 3 years = $36,000. Book value = $90,000 − $36,000 = $54,000.
Source: IRS Pub. 946 (2025), straight line method
A contractor places a $40,000 work truck (5-year MACRS property, half-year convention, 200% declining balance) in service and claims no Section 179 or bonus depreciation. Using the IRS MACRS table rates (Year 1: 20.00%, Year 2: 32.00%), what is the Year 2 deduction?
- A$16,000
- B$12,800
- C$8,000
- D$7,680
Show answer
Answer: B. Year 2 = $40,000 x 32.00% = $12,800. The MACRS table percentages are applied to the original unadjusted basis every year; 20% is the Year 1 rate, which is lower because of the half-year convention.
Source: IRS Pub. 946 (2025), Table A-1 (5-year, half-year)
A contractor buys a commercial building to use as its office and shop. Under MACRS GDS, over what recovery period is the building (not the land) depreciated?
- A39 years
- B27.5 years
- C20 years
- D15 years
Show answer
Answer: A. Nonresidential real property is recovered over 39 years under GDS using the mid-month convention. 27.5 years applies to residential rental property, and land isn't depreciable.
Source: IRS Pub. 946 (2025), Recovery Periods Under GDS
Under the MACRS half-year convention, how much depreciation is allowed in the year an asset is placed in service?
- AOne-half year's depreciation, regardless of the month it was placed in service
- BA full year's depreciation
- CDepreciation for the actual number of months in service
- DNone until the following year
Show answer
Answer: A. The half-year convention treats all property as placed in service at the midpoint of the year, so a half year of depreciation is allowed in the first year no matter which month the asset was bought.
Source: IRS Pub. 946 (2025), The half-year convention
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