Depreciation is an annual tax deduction that allows small businesses to recover costs of certain property that decreases in value over its lifetime. It is an allowance for wear and tear, deterioration, or obsolescence of the property.
As a small-business owner, you can depreciate property when you place it in service for use in your trade or business or to produce income. You stop depreciating property when it has fully recovered its cost or when it is retired from service, whichever happens first.
What is depreciable? Machinery, equipment, buildings, vehicles and furniture that are owned by the business. You cannot claim depreciation on personal property. If you use an asset for both business or investment and personal purposes, you can depreciate only the business or investment use portion. Land is never depreciable, although buildings and some land improvements may be depreciable.
To depreciate property, your business must:
- Own the property. The business is considered to own property even if the property is subject to a debt.
- Use the property in a business or income-producing activity. If your property is used to produce income, the income must be taxable. Property that is used solely for personal activities can’t be depreciated.
- Be able to assign a determinable useful life to your property. This means it must be something that wears out, decays, gets used up, becomes obsolete or loses its value from natural causes.
- Expect the property to last more than one year. The property must have a useful life that extends substantially beyond the year you placed it in service.
- Not depreciate excepted property. Excepted property includes certain intangible property, certain term interests, equipment used to build capital improvements and property placed in service and disposed of in the same year.
The IRS allows you to use different depreciation methods, depending on the type of property.
The modified accelerated cost recovery system (MACRS) is used to recover the basis of most business and investment property placed in service after 1986. MACRS consists of two depreciation systems, the general depreciation system and alternative depreciation system. Generally, these systems provide different methods and recovery periods to use in figuring depreciation deductions.
Sometimes, however, you will use the straight-line method, which lets you deduct the same amount of depreciation each year over the useful life of the property. There is also the forecast method, in which each year’s depreciation deduction is equal to the cost of the property multiplied by a fraction. The fraction is the current year’s net income from the property over the anticipated net income that the property will bring in 10 years after it is placed in service.
New for 2022
Recently, the IRS imposed new dollar limits on the Section 179 deduction. For tax years beginning in 2022, the maximum Section 179 expense deduction is $1,080,000. Your business can deduct the full price of qualified equipment with a total equipment purchase limit of $2,700,000. Also, the maximum Section 179 expense deduction for sport utility vehicles placed in service in tax years beginning in 2022 is $27,000.
This is a complex topic and there are many other provisions. We can help you decide which method is appropriate in your situation.