Because you can’t always deduct the entire cost of an asset in the year you buy it, you may need to depreciate some property and deduct a portion of the cost over several years. The property must have an anticipated usable lifespan of more than one year. This rules out purchases such as inventory. It also rules out any asset that might be expected to remain serviceable forever. Its usable life must be determinable. You must be the owner of the asset. Depreciable assets include machinery, equipment, buildings, vehicles, and furniture.
Example of Depreciable Property
You might own and operate a cab company and you purchase a car for your fleet. It costs you $30,000. You can claim a portion of that $30,000 over five years—the depreciation time span or “class life” that the IRS assigns to vehicles. This works out to a depreciation deduction of $6,000 a year. The depreciation process ends at the conclusion of the asset’s class life, when you sell it, or if it simply wears out or otherwise fails in some respect before its class life has run down. It would also end if you stopped using the asset for income-earning purposes and began using it solely for personal reasons, such as if you retired that $30,000 vehicle from your cab fleet to drive it yourself.
Methods of Depreciating Property
Most property can be depreciated using one of two methods, depending on its nature: straight-line depreciation or accelerated depreciation. As the term implies, accelerated depreciation provides the greatest tax deduction for an asset in the earlier year or years of its class life. Straight-line depreciation is the cost divided equally over the number of years of its class life. In either case, the depreciation process begins in the year in which you place the asset in service. Placing it in service does not have to mean that you’re actually using it. It just needs to be available to use for business purposes.
Straight-Line Depreciation
Your depreciation deduction isn’t simply a matter of what you paid for that asset divided by its class life. It’s a more complicated mathematical equation. You must know the adjusted basis of the property and its salvage value. The salvage value is subtracted from the adjusted basis, then the resulting figure is the amount of your depreciation deduction. You’ll then divide this figure over the number of years of its class life. Your adjusted basis is typically what you paid for the property plus costs incurred in purchasing it, such as sales tax, installation fees, freight charges, or any other additional fees or charges.
The Section 179 Deduction
The IRC provides for a special provision for accelerated depreciation: the Section 179 deduction. It allows you to claim all or most of the adjusted basis of an asset in the year of purchase if you place it in service that same year. Your depreciation deduction can be no greater than your taxable business income for the year. In other words, it can’t result in a tax refund. The most it can do is reduce or erase your taxable income. But you can carry over any balance remaining to the next tax year. Some restrictions apply to the types of property that can be depreciated this way, so check with a tax professional before moving ahead with claiming it. You may be able to qualify for the deduction if the property in question is tangible personal property, other tangible property, agricultural property, a research or storage facility, qualified real property, or some computer software. You must complete and submit Form 4562 with your tax return if you elect to use this method, if you carry over any portion of your depreciation deduction to the next tax year, or if you opt to take this deduction for a vehicle.
Property That Isn’t Depreciable
The key factor here is that depreciation is limited to property that will lose its value over time. An asset isn’t depreciable if it can conceivably gain in value. This would include certain collectibles and investments such as stocks and bonds. Land isn’t depreciable, although buildings erected on it or improvements made to it might be. Any property you use exclusively for personal reasons is not depreciable. The asset has to help you make money. Inventory isn’t depreciable because you hold it with the intention of selling it to customers. You can’t depreciate property that’s placed in service and retired or sold within the same year.
When You Have To Pay Taxes on Depreciable Property
It’s possible that you may have to “recapture” depreciation you’ve claimed under some circumstances. You would have to include it in your income for tax purposes in a future year. This would be the case if you stop using an item of depreciable property for business purposes at least 51% of the time. Depreciation you’d already claimed would be taxed along with your other sources of ordinary income, in this case, in the year the change occurred. This can also affect what you might pay in capital gains tax if you sell the asset for a profit. You must add back in the depreciation you claimed to your adjusted basis in the asset when calculating your profit for tax purposes.
