Nothing lasts forever. Things you buy age, they wear down and sometimes, they become obsolete. That’s more or less the essence of depreciation.
For federal income tax purposes, depreciation is a deduction that allows you to recover the cost or other basis of certain property. Depreciable property includes most tangible property (I like to think of tangible property as things you can touch) as well as certain intangible property. Tangible property includes buildings, rental properties, machines, cars and trucks, furnishings and equipment; land is not depreciable. Intangible property includes patents, copyrights and some kinds of software.
You’ve probably bought one of more of these things over your lifetime… How do you know if you’re entitled to deduct them for purposes of depreciation? To qualify for the depreciation deduction, you have to clear three hurdles:
- Use in business or income-producing activity. This is the most important hurdle to clear. You can’t take a depreciation deduction for property for personal use. So, right off the bat, this means that you can’t deduct your personal residence or the cost of your car used only for personal use. However, to the extent that you acquire property for business use, you can depreciate it. If you split the property between business and personal use, you can only depreciate the portion attributable to business.
- Ownership. In most cases, in order to claim a depreciation deduction, you have own the property in question. There is an exception for leased property: you may be able to deduct capital improvements (such as a new roof) to a leased property but not the underlying leased property.
- Useful life. This last hurdle is kind of tricky. The property must have a determinable useful life of more than one year (this, according to IRS, you and I might have different ideas about how long property might be useful). If it’s used for less than a year, it cannot be deducted for purposes of depreciation but it may be expensed.
You begin to depreciate your property when you place it in service for the first time. The IRS considers property “placed in service” when it is ready and available for use, not when you actually begin using it. So, for example, if you buy a car for your business, it’s ready and available once it belongs to you, not necessarily the first time you take a ride.
You stop depreciating property either when you have fully recovered your cost or other basis or when you withdraw it from service, whichever happens first. Property is considered withdrawn from service when sold or exchanged; converted to personal use; abandoned or destroyed. Be aware that when you dispose of property depreciated under MACRS, any gain is generally recaptured as ordinary income (not capital gain) up to the amount of the depreciation previously allowed or allowable for the property.
Most taxpayers will use the Modified Accelerated Cost Recovery System (MACRS) to depreciate property. To use MACRS, you have to figure out a number of factors: property class, placed in service date, basis, recovery period, convention, and depreciation method that applies to your property. You have to figure out the date and basis yourself. The IRS has a number of charts and publications to help you figure out the rest (here’s where I would normally link to the download but the relevant publication, 946, How to Depreciate Property, is 1.6MB and 120 pages long so instead, I’ll point you to the IRS Publications page and you can feel free to click away).
For most businesses, depreciating property over time can be painful since, in many cases, you’ve paid for the property in one year. Fortunately, there’s a deduction, referred to as the section 179 deduction, that allows you to claim all or part of the cost of certain property in the year that you first use it. Generally, property used to operate your business, including computers, software, furniture and cars, qualifies under section 179, but be sure to check for specific details. The limits used to be so small as to be disappointing but in recent years, the amount has been increased (albeit, temporarily, under the crazy rules in Congress) pretty significantly. For 2010, you can deduct up to $500,000, as long as you spent less than $2 million on qualified property in 2010, and you placed the property in service before year end.
To claim the depreciation deduction, you fill outfederal form 4562, Depreciation and Amortization (downloads as a pdf). If you’ve never done it before, especially without software, you know it can be pretty tricky. It’s even more complicated if you have property placed into service before 1987 or if you sold property which you previously depreciated. I highly recommend consulting with your tax professional if you have questions about how to treat property subject to depreciation.