Definition and Example of Tax Depreciation
Tax depreciation allows business owners to deduct the declining value of assets used in income-generating activities from their federal taxes. It is considered by the IRS to be an allowance for wear and tear, and it can also be applied to obsolete items that are no longer usable.
For example, if you own a truck that you use for your business, you know it will lose value the moment you drive it off the lot. It will then continue to lose value every year that you drive it. By applying tax depreciation, you can deduct a portion of the declining value of the truck from your taxes each year. This, of course, can result in considerable tax savings.
How Tax Depreciation Works
Many rules apply to which assets and how much money can be depreciated each year.
To decide whether an asset can be depreciated for tax purposes, you’ll need to consider some key criteria:
- The asset is property you own. However, there are some exceptions to this, particularly when it comes to rental property.
- It is used (at least partially) in your business activity.
- The asset has a determinable useful life. Land, for example, can’t be depreciated because it doesn’t become less useful or valuable over time.
- It will be owned and used for more than one year.
It’s important to note that some surprising items can and can’t be depreciated. For example, equipment used for capital improvement projects like new construction, expansion, or renovation can’t be depreciated, while some intangible assets including certain types of software, copyrights, and patents can be.
Because the rules are complex, it can be very helpful to check the IRS website and talk with a business accountant or tax preparer to be sure you’re following them correctly.
Using the Modified Accelerated Cost Recovery System (MACRS)
Once you’ve determined whether a specific item can be depreciated, you’ll need to use what’s called the Modified Accelerated Cost Recovery System (MACRS) to figure out your depreciation schedule (how much to deduct from your taxes each year). There are two depreciation systems within MACRS, but the one most commonly used is the general depreciation system (GDS). The alternative, depreciation system (ADS), is used if you own nonresidential property or run a farm. It also applies in very specific circumstances like operating a tangible property predominantly outside the U.S.
Straight Line vs. Accelerated Depreciation Method
The basis for tax depreciation is the property's cost multiplied by the percentage of business use. Each type of asset has a different amount of time allotted for depreciation as provided by the IRS.
Here’s an example of how tax depreciation is calculated:
You bought a car for $20,000. You use the car 80% of the time for business and 20% for personal activities. Your basis for depreciation is therefore 80% of $20,000, or $16,000. Let’s say the IRS gives you a five-year recovery period to depreciate your car. There are two common methods you can use for depreciation, as outlined below:
- Straight-line method: The straight-line method, which is the easiest to apply. It spreads the cost evenly and allows you to deduct 20% of the car’s cost every year. In other words, you can deduct 20% of $16,000, or $3,200, from your taxable income each of the five years.
- Accelerated depreciation method: This method allows for greater depreciation in the early life of an asset. One accelerated depreciation method is the double-declining method, which in this case allows you to double the amount of depreciation to 40% of your car’s cost basis in the first year. So with this method, you could deduct $6,400 from your taxes in the same year that you purchase your car and start to use it.
While these rules may seem fairly straightforward, the reality is that they can change frequently. There are also a lot of exceptions to the rules that can make a big difference in your ability to depreciate specific items.
Can Your Business Benefit From Tax Depreciation?
Whether you’ve invested in office space, computers, software, vehicles, farm equipment, inventory, land, rental property, or intangibles such as patents, chances are you own something that qualifies for tax depreciation. The question, then, is not whether you could take that depreciation, but whether you should. In some cases, the cost of hiring an accountant to accurately calculate your depreciation could be greater than the value of the depreciation itself. In other cases, tax depreciation will be an important factor in keeping your business profitable.
The value of tax depreciation varies radically depending on the type of property you’re depreciating, the type of business you run, and when and how you use the property. The best way to determine exactly how you can benefit from tax depreciation is to:
- Carefully read the most up-to-date IRS information on the subject, which is extensive
- Work closely with a business accountant to be sure you are getting the most you can out of your tax depreciation opportunities.
- Tax depreciation is a process that allows you to deduct a portion of the value of certain assets from your business taxes.
- Most businesses do have assets that qualify for tax depreciation, including computers, equipment, vehicles, software, and patents.
- You must use a system called The Modified Accelerated Cost Recovery System (MACRS) to calculate your tax depreciation for each item you choose to depreciate.
- Two common methods of depreciation are straight-line and accelerated depreciation.
- To accurately assess whether any given item can be depreciated, and to calculate a depreciation schedule, you may need to hire a business accountant.