Is Depreciation a Tax Deduction? How It Impacts Your Tax Return

Depreciation is an important tool for taxpayers who own business or income-generating assets. It allows for the recovery of costs over time, reducing taxable income and lowering tax liability. While it doesn’t involve an actual cash expense each year, its impact on taxes can be significant.

Tax Implications of Depreciation

Depreciation spreads an asset’s cost over its useful life, reducing taxable income annually instead of deducting the full purchase price upfront. The IRS sets rules to ensure consistency in tax reporting.

Certain types of depreciation, such as bonus depreciation and Section 179 expensing, allow for larger first-year deductions. Bonus depreciation, which was 100% for qualified property placed in service before 2023, is phasing down—80% in 2023, 60% in 2024, and 40% in 2025. Section 179 allows businesses to deduct the full cost of eligible assets up to a set limit, which is adjusted annually for inflation. In 2024, the Section 179 deduction limit is $1.22 million, with a phase-out threshold of $3.05 million.

When an asset is sold, depreciation affects taxable gains. If the sale price exceeds the adjusted basis (original cost minus accumulated depreciation), the difference may be subject to depreciation recapture. This portion of the gain is taxed as ordinary income rather than at the lower capital gains rate. For real estate, depreciation recapture is taxed at a maximum of 25%, while for other assets, it is taxed at the taxpayer’s ordinary income rate.

Qualifying Assets

To qualify for depreciation, an asset must be used for business or income generation, have a determinable useful life, and last more than a year. Personal-use property, land, and inventory do not qualify. The IRS assigns depreciable assets to different classes with specific recovery periods.

Real Estate

Buildings and structures used for business or rental purposes qualify for depreciation, but land does not. Residential rental properties are depreciated over 27.5 years, while commercial buildings follow a 39-year schedule under the Modified Accelerated Cost Recovery System (MACRS). Improvements such as a new roof or HVAC system may be depreciated separately.

Depreciation can significantly reduce taxable rental income. For example, a $300,000 residential rental property (excluding land value) would yield an annual depreciation deduction of approximately $10,909 ($300,000 ÷ 27.5).

Real estate professionals who materially participate in rental activities can deduct depreciation against other income. Cost segregation studies can accelerate depreciation by identifying components of a building that qualify for shorter recovery periods, such as carpeting (5 years) or landscaping (15 years).

Vehicles

Business vehicles are depreciable, but the IRS limits deductions for passenger cars. In 2024, the maximum first-year depreciation for a passenger vehicle is $20,200 with bonus depreciation or $12,200 without it. Heavy SUVs, trucks, and vans over 6,000 pounds are not subject to these limits and may qualify for full expensing under Section 179.

Depreciation for vehicles is typically calculated using MACRS with a five-year recovery period. If a vehicle is used for both business and personal purposes, only the business-use portion is depreciable. For example, if a car used 70% for business costs $40,000, only $28,000 ($40,000 × 70%) is eligible for depreciation.

Leased vehicles follow different rules, with lease payments deductible instead of depreciation. The IRS also applies an “inclusion amount” for high-value leased vehicles, reducing the deductible portion of lease payments to align with depreciation limits.

Equipment

Machinery, computers, office furniture, and other tangible business assets qualify for depreciation. The recovery period varies: computers and peripheral equipment are depreciated over five years, while office furniture and fixtures have a seven-year life under MACRS.

Businesses can accelerate deductions through Section 179 or bonus depreciation. For example, if a company purchases $50,000 in new machinery, it may deduct the full amount under Section 179 (subject to limits) or claim 60% bonus depreciation in 2024, with the remaining cost depreciated over subsequent years.

Used equipment also qualifies if it is new to the taxpayer. Repairs and maintenance costs are deductible as expenses unless they significantly extend the asset’s useful life.

Methods for Deducting Depreciation

The IRS provides multiple methods for calculating depreciation, each affecting the timing and amount of deductions. The choice of method depends on the type of asset, its expected use, and tax planning strategies.

Straight-Line

The straight-line method spreads depreciation evenly over an asset’s useful life. The asset’s cost (minus any salvage value) is divided by its recovery period.

For example, if a business purchases office furniture for $10,000 with a seven-year recovery period, the annual depreciation deduction would be $1,429 ($10,000 ÷ 7).

Straight-line depreciation is required for residential rental properties (27.5 years) and commercial buildings (39 years). It is also used when electing the Alternative Depreciation System (ADS), which applies to tax-exempt entities, foreign-use property, and certain farming equipment.

Declining Balance

The declining balance method accelerates depreciation, allowing larger deductions in the early years of an asset’s life. The double-declining balance (DDB) method applies twice the straight-line rate to the asset’s remaining book value.

For instance, if a company purchases machinery for $50,000 with a five-year recovery period, the straight-line rate is 20% (1 ÷ 5). Under DDB, the first-year depreciation is $20,000 ($50,000 × 40%). In the second year, depreciation is based on the remaining $30,000, resulting in a $12,000 deduction ($30,000 × 40%). This continues until the asset is fully depreciated or switched to straight-line for the remaining balance.

MACRS uses a variation of this method, the 200% or 150% declining balance, for most personal property.

Other Approaches

The sum-of-the-years’-digits (SYD) method accelerates deductions but at a slower rate than declining balance. It assigns a fraction to each year based on the sum of the asset’s useful life.

Units of production depreciation ties deductions to actual usage rather than time. This method is common in manufacturing, where asset wear depends on output. If a machine costing $100,000 is expected to produce 500,000 units, the per-unit depreciation is $0.20 ($100,000 ÷ 500,000). If 100,000 units are produced in a year, the depreciation deduction is $20,000.

Businesses may also use Section 179 expensing or bonus depreciation to deduct a large portion of an asset’s cost upfront.

Effects on Taxable Income

Depreciation reduces taxable income by allocating the cost of an asset over time. A company that aggressively depreciates assets in the early years enjoys immediate tax savings but may face higher taxable income later as deductions decrease.

The half-year convention, commonly applied under MACRS, assumes assets are placed in service at the midpoint of the year, reducing first-year depreciation. Mid-quarter conventions may apply if more than 40% of assets are acquired in the final quarter, altering deduction patterns.

Consequences of Skipping Depreciation

Failing to claim depreciation can lead to higher taxable income and unexpected tax liabilities when an asset is sold. The IRS assumes depreciation is taken when calculating taxable gains, meaning taxpayers may owe depreciation recapture even if they never claimed the deduction.

Correcting missed depreciation requires filing Form 3115 to request an accounting method change.

Recordkeeping Considerations

Accurate records are essential for tracking depreciation and ensuring compliance with IRS regulations. Documentation should include purchase invoices, asset descriptions, service dates, and depreciation schedules.

Businesses should track improvements and repairs separately, as capital improvements must be depreciated while routine maintenance is immediately deductible. Software solutions like QuickBooks or fixed asset management systems can automate depreciation calculations and maintain historical records.