The reducing–balance method, also known as the declining-balance method, in the initial years of an asset’s “service.” As with the straight-line method, you apply the same depreciation rate each year to what’s called the “adjusted basis” of your property. But unlike straight-line, with the reducing-balance method, you’ll be depreciating a different amount each year as the balance diminishes.
Under reducing-balance, the rate of depreciation is deliberately calculated to be higher, so most of the benefits of deducting the depreciation expense are seen early on. Typically, the percentages used are 200% (the double-declining balance formula) and 150%. Because you’re subtracting a different amount every year, you can’t simply repeat the same calculation each year, as you can with the straight-line method. As mentioned earlier, this approach is particularly useful for property whose value will decrease rapidly after you acquire it.
Doing the Math
Let’s take an example.
Let’s say you buy a computer server for your business for $25,000; you assume that there’s no salvage value. You want to use the 200% reducing-balance formula, and to depreciate this system over five years.
For your first year:
$25,000 / 5 (years) = $5,000
$5,000 x 200% = $10,000
Your depreciation deduction for the first year would be $10,000.
For your second year:
$25,000 - $10,000 = $15,000 (this is now the book value of your asset)
$15,000 / 5 = $3,000
$3,000 x 200% = $6,000
Your depreciation deduction for the second year would be $6,000.
For your third year:
$15,000 - $6,000 = $9,000
$9,000 / 5 = $1,800
$1,800 x 200% = $3,600
Your depreciation deduction for the third year would be $3,600.
For your fourth year:
$9,000 - $3,600 = $5,400
$5,400 / 5 = $1,080
$1,080 x 200% = $2,160
Your depreciation deduction for the fourth year would be $2,160.
Finally, for your fifth year:
$5,400 - $2,160 = $3,200
Your depreciation deduction for the fifth year would be $3,200.
Note that for the fifth and final year, your depreciation deduction bumped up higher than in the fourth year. Under IRS conventions, if you’re using the declining balance method, you must switch over to the straight-line method starting in the first year in which it will give you a greater or equal deduction. In this example, you’d be required to change to the straight-line method in the third year.