Depreciation is an annual tax deduction that allows small businesses to recover the costs of certain property that decreases in value over its lifetime. It’s an allowance for the 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’s retired from service, whichever happens first.
What’s 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 — a car, for instance — 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.
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’s 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.
Consider the methods
The IRS allows you to use different depreciation methods, depending on the type of property.
The modified accelerated cost recovery system 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 the 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.
Work with a tax professional to decide which method is appropriate in your situation.
New for 2021
Recently, the IRS imposed new dollar limits on the Section 179 deduction. For tax years beginning in 2021, the maximum Section 179 expense deduction is $1.05 million. This limit is reduced by the amount by which the cost of Section 179 property placed in service during the tax year exceeds $2.62 million. Also, the maximum Section 179 expense deduction for sport utility vehicles placed in service in tax years beginning in 2021 is $26,200.
This is just a brief introduction to a complex topic; there are many other provisions. Again, your best bet is to work closely with a qualified tax adviser to make sure you’re following the rules and getting all the breaks you’re entitled to.
Flowers Rieger & Associates, PLLC
6125 E. Grant Road
Tucson, AZ 85712