What is Depreciation?

Depreciation represents the loss in value of property used in a trade or business due to ware and tear, decay, or obsolescence. Tax law allows business owners to recover the cost of depreciable property via depreciation deductions.

Depreciation Rules

There are a variety of rules that deal with the amount of depreciation that may be deducted in any year.

First-year Expensing (Section 179):

First-year expensing (also referred to as the Section 179 deduction) allows you to deduct the cost of depreciable property up to a specified limit in the first year the property is placed in service. For 2015, the first-year deduction limit is $500,000.

First-year Expensing Phaseout rule:

If the cost of qualifying Section 179 property placed in service in a year exceeds $2,000,000, the first-year expensing dollar limit is reduced dollar-for-dollar by the amount the exceeds $2,000,000.

For example, if you purchase a machine for your business costing $2,400,000 during 2015, only $100,000 would be deductible in 2015 (deduction limit of $500,000 minus the 400,00, the excess over $2,000,000).

Bonus Depreciation

In addition to first-year expensing, bonus depreciation lets you deduct even more depreciation in the first year the qualified property is placed in service. Under the bonus depreciation rules, the property must be new. is another rule that allows businesses to deduct (write-off) more of the cost of new equipment in the firt year it is purchased.

The way this works is as follows:

  1. First subtract the amount of the first-year expensing deduction from the cost of new equipment.
  2. Next, deduct 50% of amount that remains after subtracting the first-year expensing amount from the cost of the new equipment
  3. Finally, multiply the remaining balance by 50% and that is your bonus depreciation.
  4. Whatever balance remains after subtracting both first-year expensing plus bonus depreciation may be depreciation under the regular MACRS depreciation rules.

So, if purchased and placed in service new equipment in 2015 worth $2,000,000, you may deduct the maximum first-year expensing deduction of $500,000 plus bonus depreciation of $750,000 (50% x [$2,000,000 minus $500,00]), for a total of $1,250,000. The remaining $750,000 ($2,000,000 - $1,250,000) may be depreciated using the

Depreciation is a noncash business expense that reduces gross revenue. It is a noncash expense because no monetary expenditure is involved when recording depreciation expense in your books. Recording depreciation in your books involves two accounts: Depreciation Expense and Accumulated Depreciation. The Depreciation Expense account is debited and the Accumulated Depreciation account is credited.

The Accumulated Depreciation account is referred to as a contra account. This means, the balance in the contra account is offset against (subtracted from) the amount(s) in the related asset account(s).

The Accumulated Depreciation account is included in the Property, Plant, and Equipment section of the Balance Sheet, which appears after the Current Assets section of the Balance sheet. The current assets section includes such assets as cash, accounts receiveable, and inventory.

For example, say you purchased office furniture and a machine two years ago when you started your business. The office furniture cost $2,000 and the machine cost $5,000. You claimed the section 179 deduction (also referred to as the first-year expensing deduction) in the same year you purchased this property.

You did not purchase any furniture or equipment in the current year.

The Property, Plant, and Equipment section (also referred to as Non-Current Assets) of your current year's balance sheet would show the following:

Balance Sheet
Property, Plant, and Equipment:  
Machinery and Equipment
Office Furninture
Less: Accumulated Depreciation
Property, Plant, and Equipment - Net
$5,000
2,000
(7,000)
$0.00

Depreciation deductions help you recover the cost of property by reducing income, which in turn, reduces taxes. For a self-employed person, not only is income tax reduced, self-employment tax is also reduced because it is based of net income.

Use Form 4562 to claim depreciation.

When to Start and Stop Depreciation

Start depreciation in the year the property is placed in service. Property is placed in service only if it is both available and ready for use. If property is only available for use but not ready for use, you cannot begin depreciation.

Example:

Property was delivered to your place of business December 20, 2012 but not installed until January 5, 2013. You must start depreciation in 2013, when the property was both available and ready for use.

If property is both ready and available for use, but is not actually being used, it is still considered placed in service and you may still deduct depreciation.

Example:

A machine was placed in service November 1, 2013. It was both available and ready for use. However, business was slow during November and December of 2013. You started using the machine in January 2014. You may start depreciation in 2013.

Stop depreciation when property is fully depreciated or when you retire it or dispose of it, whichever comes first.

Depreciable Basis of Property

The depreciable basis for business property is:

  • Original cost (the unadjusted basis)
    • This includes:
      • Money paid.
      • The value of property given up.
      • Debt you incurred, such as a loan for a car.
      • Sales taxes and any other costs related to the purchase.
    • Plus
      • Any capital (major) improvements to the property, such as a new roof on your office building, a new engine for your truck.
        • Repairs and maintenance to keep equipment in good operating condition are not capital improvements.
    • Minus
      • Depreciation and casualty losses deducted.
    • Equals
      • Adjusted basis.

File your personal and small business taxes (Schedule C)