How depreciation works

If you know you're going to have to buy a new gizmo every five years to keep doing business, then you're using up a fifth of that gizmo every year. That loss is a cost of doing business, and it will eat into your profits when you have to buy a new gizmo in year five. You get to write off that loss bit-by-bit against gross income on your taxes . . . or all at once under IRS Section 179 rules.

So, sure, the principle of depreciation seems simple enough. But in practice, the tax code for depreciating assets is perverse and complicated. And the math is just plain depressing.

The IRS breaks down the depreciation rules in Publication 946 (2008), How To Depreciate Property. These rules change every year and are responsible for employing more accountants than the Bernie Madoff trial team.

Don't be intimidated. Getting depreciation right means saving money on your taxes, and it's not as hard as it seems.

The IRS groups every piece of property into a depreciation class. Different kinds of property have different time periods over which their value depreciates. For example, “Special handling devices for food and beverage manufacture” are considered fully depreciated (ready for the junk pile) after three years, while “telephone distribution plants” have a 15-year shelf life.

The most common depreciation expenses small businesses will have to worry about are for computer gear, business vehicles and home offices.

You generally cannot deduct, in one year, the entire cost of property you purchased, either for use in your trade or business or to produce income, if the property has a useful life substantially beyond the tax year. Instead, you can depreciate it. That is, you can spread the cost over a number of years, and deduct a part of the cost each year. Instead of recovering the cost of the property by taking depreciation deductions, you can elect under Code section 179 to recover all or part of the cost of qualifying property, up to a limit, by deducting it in the year you place the qualifying property in service. For more information, refer to Publication 946, How to Depreciate Property.

The kinds of property that you can depreciate include machinery, equipment, buildings, vehicles, and furniture. You cannot claim depreciation on property held for personal purposes. If you use property, such as a car, for both business or investment and personal purposes, only the business or investment use portion may be depreciated. You may depreciate property that meets all five of the following tests.

It must be property you own.

It must be used in a business or other income–producing activity.

It must have a determinable useful life.

It must be expected to last more than one year.

It must not be excepted property. Excepted property (as described in Publication 946, How to Depreciate Property) includes certain intangible property, certain term interests, and property placed in service and disposed of in the same year.

Equipment Deductions

Small businesses can take a single deduction of up to $108,000 for equipment purchased in 2006. The deduction falls under Section 179 of the tax code and is reduced if those equipment purchases exceeded $430,000. The deduction in prior years was only about $25,000; in 2007, it will rise to $112,000. As of now, however, the higher deductions are only good through 2009.The equipment doesn't have to be new, as long as it's newly purchased and will be used at least half of the time for your business. Equipment includes computers, machines, furniture, cars and a host of other necessities. Movable equipment generally counts; property does not. You will need to fill out Form 4562 to take the deduction. Businesses that choose not to take the immediate deduction can write off portions of their equipment purchases over several years through depreciation.

Inventory.   You cannot depreciate inventory because it is not held for use in your business. Inventory is any property you hold primarily for sale to customers in the ordinary course of your business.

What Method Can You Use To Depreciate Your Property?

You must use the Modified Accelerated Cost Recovery System (MACRS) to depreciate most property.

You cannot use MACRS to depreciate the following property.

Property you placed in service before 1987.

Certain property owned or used in 1986.

Intangible property.

Films, video tapes, and recordings.

Certain corporate or partnership property acquired in a nontaxable transfer.

Property you elected to exclude from MACRS.

Intangible Property

Generally, if you can depreciate intangible property, you usually use the straight line method of depreciation. However, you can choose to depreciate certain intangible property under the income forecast method (discussed later).

You cannot depreciate intangible property that is a section 197 intangible or that otherwise does not meet all the requirements discussed earlier under What Property Can Be Depreciated.

Straight Line Method

This method lets you deduct the same amount of depreciation each year over the useful life of the property. To figure your deduction, first determine the adjusted basis, salvage value, and estimated useful life of your property. Subtract the salvage value, if any, from the adjusted basis. The balance is the total depreciation you can take over the useful life of the property.

Divide the balance by the number of years in the useful life. This gives you your yearly depreciation deduction. Unless there is a big change in adjusted basis or useful life, this amount will stay the same throughout the time you depreciate the property. If, in the first year, you use the property for less than a full year, you must prorate your depreciation deduction for the number of months in use.

Example.

In April, Frank bought a patent for $5,100 that is not a section 197 intangible. He depreciates the patent under the straight line method, using a 17-year useful life and no salvage value. He divides the $5,100 basis by 17 years to get his $300 yearly depreciation deduction. He only used the patent for 9 months during the first year, so he multiplies $300 by to get his deduction of $225 for the first year. Next year, Frank can deduct $300 for the full year.

Patents and copyrights.   If you can depreciate the cost of a patent or copyright, use the straight line method over the useful life. The useful life of a patent or copyright is the lesser of the life granted to it by the government or the remaining life when you acquire it. However, if the patent or copyright becomes valueless before the end of its useful life, you can deduct in that year any of its remaining cost or other basis.

Computer software.   Computer software is a section 197 intangible and cannot be depreciated if you acquired it in connection with the acquisition of assets constituting a business or a substantial part of a business.

Office in the home.   If your home is a personal-use single family residence and you begin to use part of your home as an office, depreciate that part of your home as nonresidential real property over 39 years (31.5 years if you began using it for business before May 13, 1993). However, if your home is an apartment in an apartment building that you own and the building is residential rental property as defined earlier under Which Property Class Applies Under GDS, depreciate the part used as an office as residential rental property over 27.5 years. See Publication 587 for a discussion of the tests you must meet to claim expenses, including depreciation, for the business use of your home.