Depreciation (Income Tax Write-off)
Apr 16 '02 (Updated Apr 26 '03)
The Bottom Line Depreciation is a way of deducting the cost of durable business property over time. It has little to do with accounting principles, but you must take it if eligible.
Note: This is a revision and expansion of part of my review under Overlooked Deductions, when I used that category for general tax information.
This is also an adjunct to the 2002 tax writeoff. Participants include laura10801, jro26, jo.com, Bryan_Carey, and mrisch. Other review links can be found here.
Depreciation is a way of accounting for the costs associated with durable goods used in a business or hobby, or for investment. Basically, an recovery period (usually less than the class life or expected life) is assigned by the IRS, and you deduct the cost of the item over that life. For example, residential real estate (residential rental property, including parts of a home that you own which is rented to other people) is depreciated over 27.5 years (40 for the Alternative Minimum Tax (AMT)); other real estate (including the portion of your house allocated to your home office) is depreciated over 39 years (40 for AMT); office furniture is depreciated over 7 years (10 for AMT), computers are generally depreciated over 5 years, computer software is generally depreciated over 3 years, etc. (Note also that AMT depreciation schedules may be slower than regular depreciation schedules, because of Accelerated Depreciation, even if the depreciation time is the same.) See IRS Publication 946 for more details, and almost all of the information in this epinion. Contrary to an otherwise excellent review in this category, salvage value is no longer considered.
Ah, yes. The property must at least be in a class which declines in value with time. Land is not depreciable, but a Stradivarius has been ruled depreciable because it is an asset class (musical instruments) which has a class life, even though it will increase in value with time.
Only the percentage of the cost corresponding to the percentage of use attributable to deductible purposes can be depreciated; costs attributable to personal use are NEVER deductible or depreciable.
Depreciation starts when the property is acquired and placed in service for deductible purposes -- there are some circumstances in which either can come first.
Durable goods which, in fact, last less than one year can be deducted in full, even if they fall into an IRS class which is depreciable. Tax preparation software in a tax preparation business is a good example.
What is the section 179 property, and why should I care?
See my review under Write-Off for more information, but the cost of section 179 property can be deducted in full, rather than being depreciated, under some circumstances.
What is listed property?
This is property subject to special rules for depreciation. It includes automobiles, "...property ... generally used for entertainment, recreation, or amusement" (quote from publication 946), a computer not owned and used exclusively for business purposes by the operator of the business, and cell-phones. If listed property is not used 50% for business, then, even if it is deductible, the AMT depreciation schedules must be used. Automobiles also have separate dollar amount limitations.
Depreciation recapture
Generally, if your business/investment use decreases (for an asset expensed under section 179), or if your business use falls below 50%, (for an asset expensed under section 179 or for listed property) during the recovery period of the asset, you need to recalculate what your depreciation would have been if you had depreciated the reduced percentage instead of expensing it, and add that back to income on form 4797 (sale of business assets).
If the property is sold during its recovery period, you also need to recapture depreciation on form 4797. Generally, ordinary depreciation may become capital gains when recaptured, but Accelerated Depreciation is recaptured as ordinary income. No recapture is required on (most) real property.
Related reviews
http://www.epinions.com/content_2495455364 on Capital Gains
http://www.epinions.com/content_911384708 on Alternative Minimum Tax (AMT)
http://www.epinions.com/content_2978128004 on Accelerated Depreciation.
http://www.epinions.com/content_2610405508 on Write-Off
Final comments
Depreciation is mandatory; whether or not you actually take deduct it, it is subtracted from the basis of the item; if you sell the item, you will be taxed on that amount, so you might as well use it.
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