Basics of Depreciation

What is depreciation?

Depreciation is a type of deduction that allows recovering the cost of certain property. It’s an annual allowance for the wear and tear, deterioration or obsolescence of the property. Most types of tangible property – except land – is depreciable. This would include buildings, vehicles and equipment. But some intangible property is also depreciable, such as patents, copyrights and computer software.

The ground rules for what can be depreciated:

  • In order to claim depreciation for a property, you must own the property.
  • Any capital improvements may also be depreciated, if the improvements were made to property you lease.
  • The property being depreciated must be used in business or in an income-producing activity.
  • If the property is used in business and for personal use, only depreciation based on the business use can be deducted.
  • The property must have a determinable useful life of more than one year.

Some things cannot be depreciated, even if the conditions above are satisfied:

  • Property placed in service and disposed of in the same year
  • Equipment used to build capital improvements. You must add otherwise allowable depreciation on the equipment during the period of construction to the basis of the improvements.
  • Certain term interests. You cannot depreciate a term interest in property created or acquired after July 27, 1989, for any period during which the remainder interest is held, directly or indirectly, by a person related to you. A term interest in property means a life interest in property, an interest in property for a term of years, or an income interest in a trust.

Depreciation begins when you place property in service for use in a trade or business, or for the production of income. That property ceases to be depreciable when you have fully recovered the property’s cost or other basis, or when you retire it from service, whichever happens first.

The taxpayer must identify several items to ensure the proper depreciation of the property:

  • Depreciation method – The Modified Accelerated Cost Recovery System (MACRS) is used to recover the basis of most business and investment property placed in service after 1986. MACRS consists of two depreciation systems: the General Depreciation System (GDS), and the Alternative Depreciation System (ADS). Generally, these two systems provide different methods and recovery periods to use in figuring depreciation deductions. See Publication 534 – Depreciating Property Placed in Service Before 1987, for depreciation methods for older property.
  • Class life of the asset – Basically, this is the time period over which the asset will be depreciated. The type of property being depreciated determines its class and how long depreciation is allowed. Property such as computers, vehicles and office furniture, for example, can be depreciated for periods of three, five, seven or 10 years. Farm buildings and certain improvements to land can be spread out over 15 or 20 years, while residential rental property is assigned a 27.5-year life. Non-residential real property can be depreciated over 31.5 or 39 years.
  • Is the asset listed property? Listed property is defined as passenger vehicles or any other property used for transportation; property generally used for entertainment, recreation or amusement; or computers and related peripheral equipment (unless used only at a regular business establishment and owned or leased by the business owner).
  • Bonus depreciation – This basically accelerates depreciation. If you qualify, it allows a business to make an additional deduction in the year the asset went into service, amounting to 50% of the cost of the asset. In 2020, you can deduct 100% of the cost of the asset.
  • Depreciable basis of the asset – To figure the depreciation deduction, you need to know the basis of your property. To get that, you need to know the cost or other basis of your property. The basis of property you buy is its cost plus additional amounts you paid for sales tax, freight charges, installation or testing fees. Those costs should be included whether they were paid with cash, a loan, a property swap or services.
  • Has the asset been expensed? A Section 179 deduction allows an asset’s expense to be deducted in the first year of its use. While widely used, there are restrictions on what qualifies for a Section 179 deduction. But even if an asset doesn’t qualify for the 179 deduction, it very likely can still be depreciated.

Use our Depreciation Deduction screens to report depreciation on your Tax Office & Associates return.

And for more information on the process of depreciation, check out IRS Publication 946 – How to Depreciate Property.

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