Publication 946: How to Depreciate Business Property

Publication 946 from the Internal Revenue Service provides the framework for depreciating business property. Depreciation is an annual tax deduction that allows a business to recover the cost of an asset over its useful life, accounting for its wear and tear or obsolescence. This deduction directly impacts a business’s taxable income.

Determining What Property Can Be Depreciated

A business must first determine if an asset is eligible for depreciation. The IRS establishes three tests that property must meet. The first is that the taxpayer must own the property, which includes assets under a financing agreement. The second test requires the property to be used in a business or income-producing activity. If an asset has mixed business and personal use, only the business-use portion is depreciable. The final requirement is that the property must have a determinable useful life of more than one year.

Tangible property like machinery, equipment, buildings, vehicles, and office furniture often qualifies. For example, a new delivery truck, a computer system for the office, or a manufacturing press would all be depreciable assets. Intangible property, such as patents or copyrights, can also be depreciated through a process called amortization. Certain property is excluded from depreciation, most notably land, which the IRS considers to have an indefinite useful life. Other non-depreciable assets include inventory and any property placed in service and disposed of in the same year.

Calculating the Basis of Depreciable Property

To calculate depreciation, a business must establish the property’s basis, which for purchased property is its cost. The cost includes the purchase price plus all amounts paid to acquire and prepare the asset for use. These additional costs can include sales tax, freight charges, and any installation or testing fees. For example, if a business buys manufacturing equipment for $50,000 and pays $3,000 in sales tax, $1,500 for freight, and $2,500 for installation, the total basis for the machine is $56,000.

Over time, the basis of an asset is reduced by any depreciation deductions already claimed, resulting in the adjusted basis. The adjusted basis is also changed by other events, such as casualty losses or the cost of improvements.

Understanding Depreciation Methods and Conventions

The primary method for calculating depreciation is the Modified Accelerated Cost Recovery System (MACRS), which is mandatory for most tangible property placed in service after 1986. MACRS includes two systems: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS is used for most property and allows for a faster recovery of an asset’s cost through accelerated depreciation methods.

Property Classes

Under GDS, assets are categorized into property classes that determine their recovery period. For example, 3-year property includes tractor units, while the 5-year class includes computers, office machinery, and vehicles. The 7-year property class covers office furniture and fixtures, and longer periods exist for assets like land improvements (15 years) and residential rental buildings (27.5 years).

Depreciation Conventions

The calculation is also affected by a convention, which determines how much depreciation can be claimed in the first and last years of service. The half-year convention is the most common, treating all property as placed in service in the middle of the year. This means one-half of the normal annual depreciation is allowed for the first year, regardless of when the asset was purchased.

The mid-quarter convention must be used if more than 40% of the total basis of property is placed in service during the last three months of the tax year. This rule is designed to prevent businesses from buying many assets late in the year to claim a full half-year of depreciation. The mid-month convention is used exclusively for residential rental and nonresidential real property.

Special Depreciation Rules and Allowances

The tax code also provides for special deductions that accelerate cost recovery, such as the Section 179 deduction and special (bonus) depreciation. These are additional deductions taken before calculating regular MACRS depreciation.

Section 179 Deduction

The Section 179 deduction allows a taxpayer to expense the cost of qualifying property, meaning the business can deduct the full purchase price from gross income in the year it is placed in service. For 2025, the maximum amount that can be expensed is $1,250,000. This deduction is primarily for tangible personal property and off-the-shelf computer software. The deduction is phased out if the total cost of property placed in service during the year exceeds the investment limit of $3,130,000 for 2025. The total deduction cannot exceed the taxpayer’s net business income for the year, but any disallowed amount can be carried forward.

Special (Bonus) Depreciation Allowance

The special depreciation allowance, or bonus depreciation, allows an additional first-year deduction for qualified property. For property placed in service in 2025, the bonus depreciation rate is 40% of its adjusted basis. This allowance is being phased out, decreasing to 20% in 2026 and eliminated in 2027. Qualified property includes new or used tangible property with a MACRS recovery period of 20 years or less. Unlike Section 179, bonus depreciation has no annual dollar or business income limits, and a business must take it unless it elects out.

Listed Property

The IRS imposes special rules for “listed property,” which includes passenger automobiles, certain other vehicles, and property used for entertainment or recreation. To use accelerated depreciation or Section 179 for listed property, the asset must pass the “more than 50% business use” test in its first year. If business use is 50% or less, the taxpayer must use the straight-line method under ADS and cannot claim Section 179 or bonus depreciation.

Reporting Depreciation and Disposing of Assets

Depreciation must be correctly reported to the IRS on Form 4562, Depreciation and Amortization. When an asset is taken out of service, its disposal must also be reported.

Information Needed for Form 4562

To complete Form 4562, a taxpayer needs specific information for each asset. The form is divided into parts for reporting the Section 179 election, special depreciation, regular MACRS depreciation, and details for listed property. Key information required includes:

• A description of the property
• The date it was placed in service
• Its cost or other basis
• The business or investment use percentage
• The calculated depreciation for the year

The Submission Process

Form 4562 is not filed by itself but is attached to the taxpayer’s annual income tax return, such as Form 1040 for individuals, Form 1120 for corporations, or Form 1065 for partnerships. A separate Form 4562 should be filed for each distinct business activity.

Disposing of Assets

When a business asset is sold, exchanged, or retired, the transaction is reported on Form 4797, Sales of Business Property. The gain or loss is calculated by comparing the sales price to the asset’s adjusted basis at the time of the sale. If the asset is sold for more than its adjusted basis, the gain may be subject to “depreciation recapture.” This means a portion of the gain, up to the total depreciation previously deducted, is taxed as ordinary income, while any excess gain is typically treated as a capital gain.