How to Depreciate Equipment for Taxes

Depreciation is an annual income tax deduction that allows a business to recover the cost of tangible property over its useful life. This process allows businesses to deduct a portion of the cost from their taxable income each year, which can lower their overall tax liability.

Identifying Depreciable Equipment and Necessary Information

For equipment to be depreciable, a business must own it and use it for an income-producing activity. If property is used for both business and personal reasons, only the business-use portion can be depreciated. The asset must also have a useful life of more than one year. Common examples of depreciable equipment include computers, machinery, vehicles, and office furniture.

Before calculating depreciation, you need the asset’s cost basis and its placed-in-service date. The cost basis is the total amount paid for the asset, including the purchase price, sales tax, freight charges, and installation fees. This figure represents the full investment required to get the equipment operational.

The placed-in-service date is the day the equipment is ready and available for its intended use, which is not always the purchase date. For example, if machinery is purchased in December but not ready for use until January of the following year, the January date is its placed-in-service date.

Choosing a Depreciation Method

The primary method for depreciating business property is the Modified Accelerated Cost Recovery System (MACRS), required for assets placed in service after 1986. MACRS includes two subsystems: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS is more common and allows for faster depreciation over a shorter period.

Under GDS, equipment is assigned to an asset class that determines its recovery period. For instance, computers are classified as 5-year property, while office furniture and fixtures are 7-year property. These classifications are detailed in IRS Publication 946.

The timing of first-year depreciation is governed by conventions. The most common is the half-year convention, which treats all property acquired during the year as if it were placed in service in the middle of that year. This means for the first year, only half of the normal annual depreciation can be claimed.

A different rule, the mid-quarter convention, must be used if more than 40% of the total cost basis of all depreciable property is placed in service during the final three months of the tax year. This convention treats all property placed in service during any quarter as being placed in service at that quarter’s midpoint.

Special Depreciation Allowances

Provisions exist that allow for more immediate cost recovery beyond standard MACRS schedules. The Section 179 deduction permits a business to treat the cost of qualifying property as an expense and deduct it in the year it is placed in service. This is an alternative to capitalizing the cost and depreciating it over several years. For the 2025 tax year, the maximum deduction is $1,250,000, but this amount is phased out if the total cost of equipment placed in service exceeds $3,130,000 and is eliminated once the cost reaches $4,380,000.

Another accelerated option is bonus depreciation, which allows an additional first-year deduction on qualified property. This deduction is taken after any Section 179 deduction but before calculating regular MACRS depreciation. For 2025, the bonus depreciation rate is 40% of the property’s adjusted basis. Unlike Section 179, bonus depreciation is not limited by business income and can be used to create a net operating loss.

These provisions are subject to change, and the bonus depreciation percentage is scheduled to decrease in subsequent years.

Calculating and Reporting Depreciation

Depreciation deductions are calculated and reported on IRS Form 4562, Depreciation and Amortization, which is filed with a business’s annual tax return. Part I of the form is used for the Section 179 deduction, where a business lists the property and calculates the amount to be expensed. Part II is for the Special Depreciation Allowance (bonus depreciation), and any remaining basis is depreciated using MACRS in Part III.

To simplify MACRS calculations, the IRS provides percentage tables in Publication 946. These tables show the percentage of an asset’s basis that can be deducted each year, incorporating the appropriate depreciation method and convention. The total deduction from Form 4562 is then carried to the appropriate business tax form, such as Schedule C for a sole proprietorship or Form 1120 for a corporation.

Disposing of Depreciated Equipment

When a business disposes of equipment by selling, exchanging, or abandoning it, there can be tax consequences. The first step is to determine the gain or loss by calculating the asset’s adjusted basis, which is its original cost basis minus all depreciation deductions taken. The gain or loss is the difference between the amount received for the asset and its adjusted basis.

If equipment is sold for more than its adjusted basis, the gain may be subject to depreciation recapture. This rule requires some or all of the gain to be treated as ordinary income instead of capital gains. The amount of gain treated as ordinary income is limited to the total depreciation deductions previously claimed on the asset.

The sale or disposition of business property is reported on IRS Form 4797, Sales of Business Property. This form is used to calculate the gain or loss and determine how much of any gain is subject to depreciation recapture. The information from Form 4797 is then transferred to the business’s main tax return.