How Does Depreciation Affect Taxes for Businesses?

What Does It Mean to Depreciate an Asset?

When you depreciate an asset, you decrease its value over time, deducting part of the decrease from your income for tax purposes. How much you deduct per year depends on your tax basis and depreciation calculation method.

How Do You Determine Your Basis?

Calculating depreciation begins with your property’s basis, generally its cost. Events that affect the property’s value may require adjustments to your basis. If you produce or hire someone to produce the property, you generally determine your basis by capitalizing it—adding the costs of producing the property to the costs of acquiring it. There are exceptions to the uniform capitalization rules when you earn, on average, $27 million or less per year.

Why Is Depreciation Tax Deductible?

Depreciation is tax deductible for the same reason business expenses are tax deductible. Over time, the depreciable property loses value. This loss of value functions as a business expense distributed over time. The primary difference is that business expenses are generally applicable in a specific tax year, while depreciable assets may hold value for many years.

What Can You Depreciate?

To be able to depreciate property, you must:

• Own it

• Use it for your business

• Be able to determine its useful life

• Expect it to be usable for more than one year

Property that loses value or usefulness over time has a useful lifespan. You cannot depreciate certain types of property, including the following:

• Land

• Property you begin using and dispose of in the same year

• Equipment you use to build capital improvements

• Certain intangible assets, as defined by the Internal Revenue Code Section 197

• Certain term interests

It can be tricky to know which assets you can depreciate. Consulting a tax professional can be helpful if you have questions.

How Do You Depreciate Assets?

To begin depreciating property, you place it into service. You place property into service by making it available for a specific business use.  You can continue to depreciate the property until you fully recover your basis or retire it from service, whichever occurs first. You retire property when you permanently withdraw it from use in your business, and you fully recover your basis once you depreciate as much as allowed. 

You should use the Modified Accelerated Cost Recovery System (MACRS) to depreciate most property. However, you should not use MACRS to depreciate specific, limited property.

What depreciation method to use when you cannot use MACRS varies by type. Properties used, acquired, or put into service in 1986 or earlier rely on a pre-1987 depreciation calculation method. Intangible property, including audio and video recordings, may use straight-line or income forecast depreciation. And, if you can depreciate using a method that is not based on a term of years, you may elect to depreciate it using an alternative technique.

Modified Accelerated Cost Recovery System (MACRS)

MACRS includes two alternatives: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). You must use ADS for specific properties and may elect to use it for others.

General Depreciation System (GDS)

Under GDS, there are nine classifications of property:

• Three-year

• Five-year

• Seven-year

• Ten-year

• Fifteen-year

• Twenty-year

• Twenty-five-year

• Residential rental property (27.5 years)

• Nonresidential real property (39 years)

Each of these classifications includes specific, identified types of property.

Using GDS, you depreciate property over a recovery period based on its classification. 

How much you depreciate per year depends on what depreciation method you use between the:

• Two-hundred percent declining balance method

• One-hundred-fifty percent declining balance method

• Straight-line method

For instructions regarding how to calculate depreciation for the various methods, IRS Publication 946, How to Depreciate Property, is a good place to start. 

Alternative Depreciation System (ADS)

Some of the types of property for which you must use ADS include:

• Qualified improvement property held by an electing real property business and nonresidential or residential real property

• Property with a GDS recovery period of 10 years or more and held by an electing farming business

• Tax-exempt use or bond-financed property

• Tangible property used predominantly outside the United States

• Property used 50% or less for a qualified business use

The ADS requires the straight-line method and sets alternative recovery periods.

Can You Deduct Anything Else?

Depreciating assets allows you to spread out your deductions over time, saving on future tax bills. However, it is natural to wonder whether you can deduct some expenses sooner when it makes sense.

What Is a Section 179 Deduction?

When you take an Internal Revenue Code Section 179 deduction, you can deduct the entire asset as a business expense in the year you put it into service, subject to dollar and income-based limitations.

Property that qualifies for the Section 179 deduction may include:

• Tangible personal property

• Specific other tangible property

• Single-purpose agricultural or horticultural structures

• Non-structural petroleum storage facilities

• Off-the-shelf computer software

• Non-structural improvements to nonresidential real property interiors

• Improvements to roofs and HVAC, fire protection, and security systems of nonresidential real property

You have the option to deduct only part of the expenses under Section 179 and depreciate the remaining value.

What Is a Special Depreciation Allowance?

You can also claim a special depreciation allowance and recover part of the cost of qualified property. The deductible percentage varies from 50% to 100% depending on the type of property and when it is placed in use. Types of qualified property include:

• Machinery or equipment used exclusively to collect, distribute, or recycle reusable and recyclable materials

• Tangible property with a 20-year or less recovery period depreciated under MACRS

• Certain depreciated computer software; water utilities; film, television, and live theatrical productions; and plants acquired after September 27, 2017

• Long production period property and noncommercial aircraft

• Certain fruit- and nut-bearing plants

You may only utilize the special depreciation allowance the first year that property is placed in service.

How Depreciation Affects Taxes

When you depreciate assets over time, you can distribute deductions for high-value items over many years, making your income-to-expense ratio more predictable and stable. Additionally, depreciation allows you to deduct more overall when your property is worth more than you can deduct in a single year.

Effectively depreciating assets requires an understanding of complex laws. Although we covered the basics here, we only touched the tip of the iceberg. If you want to take advantage of depreciation tax incentives, consider consulting an experienced accountant or tax attorney for assistance.

Disclaimer: Bizee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.