General Information on Depreciation

The first part of this chapter gives you basic information on what property can and cannot be depreciated, when to begin and end depreciation, and how to claim depreciation.

What Can Be Depreciated

You can depreciate property only if it meets all the following requirements.

1. It must be used in business or held for the production of income.
2. It must have a useful life that extends substantially beyond the year it is placed in service.
3. It must be something that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes.

Depreciable property may be tangible or intangible.

Tangible Property

Tangible property is property you can see or touch and includes both real and personal property. Tangible personal property includes machinery or equipment and anything else you can see or touch except real property. Real property is land, buildings, and generally anything built or constructed on land, growing on land, or attached to land. However, land itself is never depreciable.

Livestock. Livestock purchased for draft, breeding, or dairy purposes that is not kept in an inventory account can be depreciated.

Raised livestock. Livestock you raise usually has no depreciable basis because the costs of raising them are deducted and not added to their basis. However, if you purchase immature livestock for draft, dairy, or breeding purposes, you can depreciate your initial costs when the livestock reach the age when they can be worked, milked, or bred.

Irrigation systems and water wells. You can depreciate irrigation systems and wells composed of masonry, concrete, tile, metal, or wood. In addition, you can depreciate costs for moving dirt to make irrigation systems and water wells composed of these materials. However, land preparation costs for center pivot irrigation systems are not depreciable.

Partial business use. If you use tangible property (including your car) for business or investment purposes and for personal purposes, you can deduct depreciation on the part used for business or investment.

For example, if you use your car for farm business, you can deduct depreciation for the part you use in farming. If you also use it for investment purposes, you can depreciate the part used for investment.

If you use part of your home for business, you may be able to take a depreciation deduction for its business use. For more information, see Business Use of Your Home in chapter 5.

Intangible Property

Intangible property is generally any property that has value but you cannot see or touch. It includes items such as computer software, copyrights, patents, franchises, trademarks, and trade names.

Computer software. Computer software includes any program used to cause a computer to perform a desired function. It also includes any data base or similar item in the public domain and incidental to the operation of qualifying software.

Generally, you can depreciate software over 36 months. However, if you acquired the software in connection with the acquisition of a substantial portion of a business, you can depreciate it over 36 months only if it meets the following requirements.

• It is readily available for purchase by the general public.
• It is not subject to an exclusive license.
• It has not been substantially modified.

If you acquire software in connection with the acquisition of a substantial portion of a business and it does not meet the previous requirements, you must amortize it over 15 years (rather than depreciate it). For more information on amortization, see Amortization, later.

Computer software with a useful life of less than one year is deductible as a current business expense.

Year 2000 costs. Year 2000 costs are costs of converting or replacing computer software to recognize dates beginning in the year 2000. They include costs of the following.

• Manually converting existing software.
• Developing new software.
• Purchasing or leasing new software to replace existing software.
• Developing or purchasing software tools to assist you in converting your existing software.

Treat year 2000 costs as computer software for depreciation purposes.

Any change in the treatment of year 2000 costs to allow them to be treated as computer software for depreciation purposes is a change in accounting method. If you want to make this type of change, follow the automatic change procedures in Revenue Procedure 99-49 in Internal Revenue Bulletin No. 1999-52.

Leased software. If you lease software, treat the rental payments the same as any other rental payments.

What Cannot Be Depreciated

To determine if you can depreciate any item, you must know not only what you can depreciate but what you cannot depreciate.

Property placed in service and disposed of in the same year. You cannot depreciate property you place in service and dispose of in the same year. Determining when property is placed in service is explained later.

Land. You can never depreciate the cost of land because land does not wear out, become obsolete, or get used up. The cost of land generally includes the cost of clearing, grading, planting, and landscaping because these expenses are all part of the cost of the land itself. For information on land preparation costs you may be able to depreciate, see chapter 1 of Publication 946.

Dams, ponds, and terraces. In general, you cannot depreciate earthen dams, ponds, and terraces unless the structures have a determinable useful life.

Inventory. You can never depreciate inventory. Inventory is any property you hold primarily for sale to customers in the ordinary course of your business.

Equipment used to build capital improvements. You cannot deduct depreciation on equipment used to build your own capital improvements. You must add depreciation on equipment used during the period of construction to the basis of your improvements. See Uniform Capitalization Rules in chapter 7.

Leased property. You can depreciate leased property only if you retain the incidents of ownership for the property (explained later). This means you bear the burden of exhaustion of the capital investment in the property. Therefore, if you lease property to use in your trade or business or for the production of income, you cannot depreciate its cost. You can, however, depreciate any capital improvements you make to the leased property. See Additions or improvements to property in chapter 3 of Publication 946.

If you lease property to someone, you generally can depreciate its cost even if the lessee (the person leasing from you) has agreed to preserve, replace, renew, and maintain the property. However, you cannot depreciate the cost of the property if the lease provides that the lessee is to maintain the property and return to you the same property or its equivalent in value at the expiration of the lease in as good condition and value as when leased.

Incidents of ownership. Incidents of ownership include the following.

• The legal title.
• The legal obligation to pay for it.
• The responsibility to pay its maintenance and operating expenses.
• The duty to pay any taxes.
• The risk of loss if the property is destroyed, condemned, or diminished in value through obsolescence or exhaustion.

Intangible property. The following are two types of intangible property that you can never depreciate.

Goodwill. You can never depreciate goodwill because its useful life cannot be determined.

However, if you acquired a business after August 10, 1993 (July 25, 1991, if elected), and part of the price included goodwill, you may be able to amortize the cost of the goodwill over 15 years. For more information, see Amortization, later.

Trademark or trade name. In general, you cannot depreciate the cost of a trademark or trade name. However, you may be able to amortize over 15 years the cost of a trademark or trade name acquired after August 10, 1993 (after July 25, 1991, if elected). For more information, see Amortization, later.

When Depreciation Begins and Ends

You begin to depreciate your property when you place it in service for use in your trade or business or for the production of income. You stop depreciating property either when you have fully recovered your cost or other basis or when you retire it from service, whichever happens first.

Placed in Service

For depreciation purposes, property is placed in service when it is ready and available for a specific use, whether in a trade or business, the production of income, a tax-exempt activity, or a personal activity. Even if you are not using the property, it is in service when it is ready and available for its specific use.

Example 1. You bought a home and used it as your personal home for several years before you converted it to rental property. Although its specific use was personal and no depreciation was allowable, you placed the home in service when you began using it as your home. You can claim a depreciation deduction in the year you converted it to rental property because its use changed to an income-producing use at that time. The property is residential rental property and is depreciated over 27.5 years under the General Depreciation System (GDS) using the straight line method.

Example 2. You bought a planter for your farm business late in the year after harvest was over. You can take a depreciation deduction for the planter for that year because it was ready and available for its specific use.

Cost or other basis fully recovered. You have fully recovered your cost or other basis when you have taken section 179 and depreciation deductions equal to your cost or investment in the property.

Retired From Service

You stop depreciating property when you retire it from service. You retire property from service when you permanently withdraw it from use in a trade or business or in the production of income.

You retire property from service in the following ways.

• Sale or exchange.
• Abandonment.
• Destruction.

For information on abandonment of property, see chapter 10. For information on destroyed property, see chapter 13.

Incorrect Amount of Depreciation Deducted

If you deducted an incorrect amount of depreciation in any year, you may be able to make a correction by filing an amended return. See Amended Return, later. If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation. See Changing Your Accounting Method, later.

Basis adjustment. Even if you do not claim depreciation you are entitled to deduct, you must reduce the basis of the property by the full amount of depreciation you were entitled to deduct. If you deduct more depreciation than you should have, you must decrease your basis by any amount deducted from which you received a tax benefit.

Amended Return

If you deducted an incorrect amount of depreciation, you can file an amended return to correct the following.

• A mathematical error made in any year.
• A posting error made in any year (for example, omitting an asset from the depreciation schedule).
• The depreciation for property for which you have not adopted a method of accounting.

You must file the amended return by the later of the following.

• 3 years from the date you filed your original return for the year in which you deducted the incorrect amount.
• 2 years from the time you paid your tax for that year.

A return filed early is considered filed on the due date.

Two or more consecutive returns. If you deducted an incorrect amount of depreciation for the property on two or more consecutively filed tax returns, you have adopted a method of accounting for that property. Once you have adopted a method of accounting, you cannot change the method by filing amended returns. You must change your method of accounting.

Changing Your Accounting Method

When you deduct an incorrect amount of depreciation on two or more consecutively filed tax returns, you can claim the correct amount only by changing your method of accounting for depreciation. You can then take into account any unclaimed or excess depreciation from years before the year of change.

Approval required. You must get IRS approval to change your method of accounting. File Form 3115, Application for Change in Accounting Method, to request a change to a permissible method of accounting for the depreciation. Revenue Procedure 97-27 in Cumulative Bulletin 1997-1 gives general instructions for getting approval. Cumulative Bulletins are available at many libraries and IRS offices. There is a user fee for changing your method of accounting under Revenue Procedure 97-27.

Automatic approval. You may be able to get automatic approval from the IRS to change your method of accounting if you used an unallowable method of accounting for depreciation in at least the 2 years immediately before the year of change and the property for which you are changing the method meets all the following conditions.

1. It is property for which, under your unallowable method of accounting, you claimed either no depreciation or an incorrect amount.
2. It is property for which you figured depreciation using one of the following.
   1. Pre-1981 rules.
   2. Accelerated Cost Recovery System (ACRS).
   3. Modified Accelerated Cost Recovery System (MACRS).
3. It is property you owned at the beginning of the year of change.

File Form 3115 to request a change to a permissible method of accounting for depreciation. Revenue Procedure 99-49 and section 2.01 of its Appendix, which can be found in Internal Revenue Bulletin No. 1999-52, have instructions for getting automatic approval and list exceptions to the automatic approval procedures.

Exceptions. You generally cannot use the automatic approval procedure in any of the following situations.

• You are under examination by the IRS.
• You are before a federal court or an appeals office for any income tax issue and the method of accounting for depreciation to be changed is an issue under consideration by the federal court or appeals office.
• You are correcting a mathematical or posting error. See Amended Return, earlier.
• During the last five years (including the year of change), you changed the same method of accounting for depreciation (with or without obtaining IRS approval).
• During the last five years (including the year of change), you filed a Form 3115 to change the same method of accounting for depreciation but did not make the change because the Form 3115 was withdrawn, not perfected, denied, or not granted.

Also, see other exceptions listed in section 4.02 of Revenue Procedure 99-49 and section 2.01(2)(b) in the Appendix of this revenue procedure.

How To Claim Depreciation

Use Form 4562 to claim depreciation and amortization deductions and to elect the section 179 deduction, discussed next. Amortization is discussed later. For more information on completing Form 4562, refer to its instructions.

It is important to keep good records for property you depreciate. Do not file these records with your return. Instead, you should keep them as part of the records of the depreciated property. They will help you verify the accuracy of the information on Form 4562. For general information on recordkeeping, see Publication 583, Starting a Business and Keeping Records. For specific information on keeping records for section 179 property and listed property, see Publication 946.

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