Can Depreciation Offset Ordinary Income?

Depreciation serves as an accounting method to gradually expense the cost of a tangible asset over its projected useful life. Ordinary income refers to earnings from regular business operations, wages, salaries, and other routine sources. These two concepts intersect significantly for tax purposes, as depreciation can directly influence a taxpayer’s ordinary income liability.

Understanding Depreciation

Depreciation’s primary purpose is to systematically allocate the cost of an asset over the periods it generates revenue. This process recognizes that assets, such as machinery or buildings, lose value due to wear and tear, obsolescence, or usage over time. This aligns expenses with the income they help produce, providing a more accurate financial picture. For tax purposes, depreciation allows businesses and individuals to recover the cost of eligible property, thereby reducing taxable income.

Property eligible for depreciation includes tangible assets used in a business or for income-producing activities. These assets must have a determinable useful life and be expected to last more than one year. Examples include buildings, machinery, vehicles, and furniture. Land is not depreciable because it generally does not wear out or become obsolete.

The most common method for tax depreciation in the U.S. is the Modified Accelerated Cost Recovery System (MACRS). MACRS generally allows for larger deductions in the earlier years of an asset’s life and smaller deductions later, accelerating the cost recovery. In contrast, Straight-Line Depreciation spreads the asset’s cost evenly over its useful life, resulting in the same deduction amount each year.

Beyond regular depreciation methods, Section 179 expense and bonus depreciation offer accelerated deductions. Section 179 allows businesses to deduct the full cost of qualifying property, up to certain limits, in the year it is placed in service. For 2025, the maximum Section 179 deduction is $1,250,000, and this begins to phase out if more than $3,130,000 of qualifying property is placed in service. Bonus depreciation permits businesses to immediately deduct a large percentage of the purchase price of eligible assets in the year of acquisition. While 100% bonus depreciation was available for some time, it is currently phasing down, with 40% allowed for property placed in service in 2025.

How Depreciation Reduces Taxable Income

Depreciation is categorized as a non-cash expense, meaning it reduces a business’s reported profit without involving an actual outflow of cash in the current period. This characteristic allows depreciation to directly lower an entity’s taxable income. By decreasing taxable income, the amount of ordinary income subject to tax is reduced, leading to a lower tax liability.

When a business calculates its net income, it subtracts expenses from its gross revenue. Depreciation, as an expense, contributes to this reduction. For example, if a business has $100,000 in gross income and $20,000 in depreciation expense, its taxable income is reduced to $80,000. This lower taxable income then results in less tax owed, effectively allowing the business to retain more of its cash flow. The tax savings generated from depreciation can then be reinvested into the business or used for other purposes.

Key Rules Affecting Depreciation Deductions

While depreciation offers significant tax benefits, several rules can limit or modify its impact on offsetting ordinary income. These rules ensure that deductions are applied appropriately and prevent unintended tax advantages.

Passive Activity Loss (PAL) Rules

The Passive Activity Loss (PAL) rules, outlined in Internal Revenue Code Section 469, aim to prevent taxpayers from using losses from passive activities to offset active income, such as wages or income from an actively managed business. Rental real estate activities are generally considered passive activities, even if the taxpayer materially participates. Losses generated from passive activities, including those stemming from depreciation, can only offset income from other passive activities.

If passive losses exceed passive income in a given year, they are suspended and carried forward indefinitely until passive income is generated in a future year or the passive activity is sold. Individuals who “actively participate” in rental real estate activities may be able to deduct up to $25,000 of passive losses against non-passive income. This $25,000 allowance begins to phase out when Modified Adjusted Gross Income (MAGI) exceeds $100,000 and is fully phased out at $150,000. Another exception applies to “real estate professionals,” who, if they meet specific material participation tests, can treat their rental real estate income or loss as non-passive, allowing losses to offset ordinary income.

At-Risk Rules

The at-risk rules limit the amount of loss, including those generated by depreciation, that a taxpayer can deduct from an activity. These rules prevent taxpayers from deducting losses that exceed their actual economic investment in the activity. A taxpayer’s at-risk amount generally includes cash and the adjusted basis of property contributed to the activity. It also includes certain borrowed amounts for which the taxpayer is personally liable or has pledged property as security.

If the amount of losses exceeds the amount the taxpayer has at risk, the excess loss is suspended and carried forward to future years. These suspended losses can then be deducted in any subsequent year when the taxpayer’s at-risk amount in the activity increases. The at-risk rules ensure that tax deductions reflect a taxpayer’s true financial exposure.

Depreciation Recapture

Depreciation recapture is a tax provision that comes into play when depreciated property is sold at a gain. It essentially “recaptures” the tax benefits previously received through depreciation deductions. When an asset is sold for more than its adjusted basis (original cost minus accumulated depreciation), some or all of the gain may be taxed as ordinary income, rather than at potentially lower capital gains rates.

There are two main types of depreciation recapture: Section 1245 and Section 1250. Section 1245 generally applies to personal property, such as machinery, equipment, and vehicles. When Section 1245 property is sold, any gain up to the amount of depreciation previously claimed is recaptured as ordinary income. Section 1250 applies to real property, like buildings. For Section 1250 property, if accelerated depreciation was used, the difference between accelerated depreciation and straight-line depreciation is recaptured as ordinary income. However, for real property depreciated using the straight-line method, the gain attributable to depreciation is taxed at a maximum rate of 25%, known as “unrecaptured Section 1250 gain,” rather than at ordinary income rates. This recapture mechanism ensures that the tax benefits from depreciation are partially offset when the asset is disposed of, especially if it retains significant value.