How to Do Depreciation for Tax Purposes

Depreciation is an accounting method allowing a business to recover an asset’s cost over time. Instead of deducting the entire cost in the year of purchase, depreciation spreads it over the asset’s useful life to account for wear and tear or a decline in value. This annual deduction lowers a business’s taxable income and tax liability. The process applies to tangible assets, which are physical items expected to last more than one year, by matching their cost to the periods in which they help generate revenue.

Determining What Can Be Depreciated

To be depreciable, an asset must meet four specific criteria. If an asset is used for both business and personal purposes, only the portion used for business is eligible for depreciation. The property must meet the following requirements:

• You must legally own the property, holding the title even if you have a loan on it.
• The property must be used in a business or other income-producing activity.
• The asset must have a determinable useful life, meaning it wears out, decays, or loses value.
• The property must be expected to last for more than one year.

Common examples of depreciable property include computers, office furniture, machinery, equipment, and vehicles used for business operations. Buildings that a business owns and uses are also depreciable, as they have a limited lifespan and contribute to revenue generation over several years.

What Cannot Be Depreciated

Certain types of property are excluded from depreciation. The most significant non-depreciable asset is land because it is not considered to wear out or become obsolete. When a business purchases real estate, the total cost must be allocated between the land and the building, as only the building portion can be depreciated.

Other assets that cannot be depreciated include inventory, which is property held for sale to customers. The costs of inventory are recovered through the cost of goods sold when the items are sold. Additionally, assets placed in service and disposed of in the same year do not qualify for depreciation.

Information Required to Calculate Depreciation

Before calculating the depreciation deduction for any business asset, you must gather the asset’s cost basis, its placed-in-service date, and its recovery period. These details are the inputs for any depreciation formula and ensure the calculation complies with tax regulations.

Cost Basis

An asset’s cost basis is the total amount you paid to acquire it, including the purchase price and any additional costs needed to get it ready for use. These can include sales tax, freight or shipping charges, and installation or setup fees. For example, if a business buys equipment for $50,000 and pays $2,500 in sales tax, $1,000 for delivery, and $1,500 for installation, the total cost basis is $55,000.

Placed-in-Service Date

The placed-in-service date is when an asset is ready and available for its intended use in your business, which is not always the purchase date. If you buy a computer in December but do not set it up for use until January of the next year, the placed-in-service date is in January. This date determines the tax year you can begin claiming depreciation and which depreciation convention applies, dictating how much depreciation you can claim in the first year.

Recovery Period

The recovery period is the number of years over which you will depreciate an asset, as defined by the Internal Revenue Service (IRS). For tax purposes, most tangible property is depreciated using the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, every depreciable asset is assigned to a property class with a designated recovery period.

These recovery periods are predetermined and are not based on an individual asset’s expected useful life. For example, computers and light-duty trucks are classified as 5-year property, while office furniture is 7-year property. Residential rental properties have a recovery period of 27.5 years, and commercial buildings have one of 39 years. A list of asset classes is in IRS Publication 946, “How To Depreciate Property.”

Salvage Value

Salvage value is the estimated resale value of an asset at the end of its useful life. For many accounting purposes, this value is subtracted from the asset’s cost to determine the depreciable amount. However, for tax depreciation calculated under the MACRS system, the salvage value of an asset is treated as zero. This simplifies the calculation, as the entire cost basis is depreciated over its recovery period.

Common Depreciation Methods

The primary system for calculating depreciation for federal tax purposes is the Modified Accelerated Cost Recovery System (MACRS), which is mandatory for most tangible property placed in service after 1986. MACRS accelerates the recovery of an asset’s cost, allowing for larger deductions in the earlier years of its life. This provides a greater tax benefit sooner compared to methods that spread the cost evenly.

MACRS Overview

MACRS is divided into two subsystems: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS is the most common system and uses accelerated methods, such as the 200% and 150% declining balance methods, to front-load depreciation deductions.

The Alternative Depreciation System (ADS) is required for certain property, such as property used mainly outside the U.S. or financed with tax-exempt bonds. ADS uses the straight-line method and has longer recovery periods than GDS. Taxpayers can also elect to use ADS for any class of property, which may benefit businesses expecting to be in a higher tax bracket in future years.

Depreciation Conventions

A component of MACRS calculations is the application of a depreciation convention, which determines the portion of a full year’s depreciation that can be claimed in the first and last years of service. The type of property and its placed-in-service date dictate which of the three conventions must be used.

The half-year convention is the most common and assumes property was placed in service in the middle of the tax year, allowing you to claim one-half of the normal first-year depreciation. The mid-quarter convention must be used if more than 40% of the total basis of all personal property is placed in service during the last three months of the tax year. The mid-month convention is used for residential rental and nonresidential real property, treating the property as placed in service in the middle of the month it was acquired.

Calculation Example

To illustrate MACRS, consider a business that buys a new computer for $5,000. A computer is classified as 5-year property. Assuming the business uses the GDS method and the half-year convention, the depreciation is calculated using IRS-provided percentage tables. For 5-year property under the 200% declining balance method, the first-year rate is 20%.

The first-year depreciation deduction would be $1,000 ($5,000 cost basis x 20%). In the second year, the rate is 32%, resulting in a deduction of $1,600 ($5,000 x 32%). This continues according to the IRS table percentages until the full cost basis is recovered.

Special Depreciation Allowances

In addition to regular MACRS depreciation, tax law provides for special allowances that can increase deductions in the first year an asset is placed in service. These provisions, the Section 179 deduction and bonus depreciation, are designed to encourage businesses to invest in property by allowing an immediate write-off of all or a large portion of an asset’s cost.

Section 179 Deduction

The Section 179 deduction allows a business to treat the cost of qualifying property as an expense instead of a capital expenditure, deducting the full purchase price in the year it is placed in service. Qualifying property is tangible personal property, such as machinery and vehicles, purchased for business use.

This deduction has limitations. For 2025, the annual dollar limit on the total property cost that can be expensed is $1,250,000. The deduction also begins to phase out if the total cost of qualifying property placed in service during the year exceeds $3,130,000 for 2025. The Section 179 deduction cannot exceed the business’s net taxable income for the year.

Bonus Depreciation

Bonus depreciation is another first-year allowance that permits an additional deduction for the cost of qualifying new and used property. It is automatically allowed unless the taxpayer elects out of it. For property placed in service in 2025, the bonus depreciation rate is 40% of the property’s adjusted basis, a percentage scheduled to decrease in future years.

Unlike Section 179, bonus depreciation is not limited by a business’s taxable income, meaning it can be claimed even if it results in a net operating loss. A business would apply the Section 179 deduction first, then bonus depreciation to the remaining basis, and finally calculate regular MACRS depreciation on any basis that is left.

Reporting Depreciation on Tax Forms

After calculating the total depreciation deduction, the final step is to report these figures to the IRS on Form 4562, Depreciation and Amortization. This form consolidates all depreciation-related deductions before they are carried to the main business tax return.

The structure of Form 4562 handles different types of depreciation separately. Part I is for the Section 179 deduction, where you list qualifying property and calculate the total expense. Part II is used to report the Special Depreciation Allowance, or bonus depreciation. Part III is for reporting regular MACRS depreciation for assets placed in service during the current tax year.

Once Form 4562 is complete, the total depreciation deduction is transferred to the appropriate line on the business’s main tax form. For a sole proprietor, this is Schedule C (Form 1040). For a partnership, it is Form 1065, and for a corporation, it is Form 1120.