Depreciation

Depreciation is the annual deduction for the cost of an asset that is used up over time in a business or income-producing activity. Internal Revenue Code section 167(a) allows "a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)" of property used in a trade or business or held for the production of income. Section 168 then supplies the actual system most taxpayers use, the modified accelerated cost recovery system, which assigns each kind of property a recovery period, a method and a convention.

The word is worth separating from its everyday meaning, because the two senses come apart in a way that costs people money. In ordinary speech, depreciation is a thing losing value: a new car worth less the moment it leaves the lot, or an insurer paying the depreciated value of a ten-year-old roof. Neither of those is a tax deduction. Tax depreciation does not track what an asset is worth at all. It runs on a statutory schedule applied to what the asset cost, and it exists only where the asset is used to earn income.

The reason the tax system spreads the cost rather than allowing it up front is a matching one: an asset that produces income for a decade should have its cost recognized across that decade rather than all in the year it was bought. The consequence for the taxpayer is that depreciation defers tax rather than cancelling it. Section 1016(a)(2) reduces the asset's basis by the depreciation allowed, "but not less than the amount allowable", so the reduction happens whether or not the deduction was claimed, and the smaller basis produces a larger gain when the asset is sold. What comes back at that point is the subject of depreciation recapture.

Under the modified accelerated cost recovery system the shape of the deduction depends on what the asset is. Most business equipment falls into a 3, 5, 7 or 10-year class and uses the 200% declining balance method, which front-loads the deduction and later switches to straight line when that gives a bigger allowance. Some 15 and 20-year property uses 150% declining balance instead. Real property has no such choice: section 168(b)(3) forces the straight line method on residential rental property and nonresidential real property, and section 168(c) sets the recovery periods at 27.5 years and 39 years respectively.

Conventions decide the first and last years. Equipment generally uses a half-year convention, so only half a year's deduction is available in the year of purchase regardless of the month. Real property uses a mid-month convention, so the deduction starts in the middle of the month the property was placed in service. "Placed in service" is the trigger, not the purchase date, and for a rental that means available for rent rather than occupied.

Two structural points cause most of the confusion. First, land is never depreciable, because it does not wear out and has no determinable useful life, which is why buying real estate requires the price to be allocated between land and improvements before any deduction exists. Second, personal use kills the deduction entirely: a laptop used half for a business and half for family email is depreciable only as to the business share, and a personal car is not depreciable at all no matter how much value it loses.

Several provisions let a business accelerate all this rather than waiting out the recovery period. Section 179 allows an immediate expensing election within annual dollar limits, section 168(k) bonus depreciation allows an immediate deduction for qualifying property with a recovery period of 20 years or less (which excludes buildings), a de minimis safe harbor allows small purchases to be expensed rather than capitalized, and a cost segregation study reclassifies parts of a building into shorter-lived categories. Each is its own subject with its own limits and its own consequences on sale.

Determine the asset's basis, subtract anything not depreciable such as land, identify the recovery period and method for that class of property, apply the convention for the first year, and repeat until the basis is recovered. The running total sits on a depreciation schedule that has to survive as long as the asset does, because it drives the gain calculation on sale.

A hypothetical. Rafi buys a small commercial building for $500,000, of which $110,000 is allocated to the land, leaving $390,000 of depreciable basis. Nonresidential real property is straight line over 39 years, so a full year's deduction is 390,000 divided by 39, or $10,000. Because real property uses the mid-month convention, his first-year deduction is prorated from the middle of the month he placed the building in service rather than being a full $10,000.

After six full years he has taken about $60,000 of depreciation, and his adjusted basis in the building has fallen from $390,000 to roughly $330,000. Note what has happened to his eventual gain: if he sells for what he paid, he still has a taxable gain of about $60,000, and none of it represents the building going up in value. That is the deferral coming due.

Equipment behaves differently in the early years. A $21,000 machine in the 7-year class would be $3,000 a year on straight line, but the default method is 200% declining balance with a half-year convention, so the first year is smaller than a full share and the middle years are larger.

Pros

• Converts a capital outlay into deductions against ordinary business or rental income.
• On a rental it frequently turns positive cash flow into a taxable loss on paper, because it is a deduction that requires no cash.
• Acceleration routes exist for businesses that want the deduction sooner, including section 179 expensing and bonus depreciation.
• The schedule is mechanical, so once the classification is right the annual figure is not a judgment call.

Cons

• It is a deferral, not a permanent benefit. The deduction reduces basis and resurfaces as taxable gain on sale.
• Basis falls by the amount allowable whether or not you claim it, so forgetting to depreciate is the worst of both outcomes.
• Getting the land and building split wrong misstates every year's deduction and the gain on sale.
• Real property recovery periods are long, so the annual deduction on a building is small relative to its price.
• Mixed personal use requires allocation and record-keeping that many owners do not maintain.