1. Overview of Depreciation
Introduction
Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property.
This chapter discusses the general rules for depreciating property. It explains what property can be depreciated, when depreciation begins and ends, whether MACRS can be used to figure depreciation, what the basis for depreciation is, and how to treat improvements. It also explains whether you have to file Form 4562 and how you can correct depreciation claimed incorrectly in a previous year.
Useful Items You may want to see:
Publication
- 534 Depreciating Property Placed in Service Before 1987
- 535 Business Expenses
- 538 Accounting Periods and Methods
- 551 Basis of Assets
Form (and Instructions)
- Sch C (Form 1040) Profit or Loss From Business
- Sch C-EZ (Form 1040) Net Profit From Business
- 2106 Employee Business Expenses
- 2106-EZ Unreimbursed Employee Business Expenses
- 3115 Application for Change in Accounting Method
- 4562 Depreciation and Amortization
See chapter 7 for information about getting publications and forms.
What Property Can Be Depreciated?
- Adjusted basis
- Amortization
- Basis
- Commuting
- Disposition
- Fair market value
- Goodwill
- Intangible property
- Listed property
- Placed in service
- Remainder interest
- Tangible property
- Term interest
- Useful life
You can depreciate most types of tangible property (except land), such as buildings, machinery, vehicles, furniture, and equipment. You also can depreciate certain intangible property, such as patents, copyrights, and computer software.
To be depreciable, the property must meet all the following requirements.
- It must be property you own.
- It must be used in your business or income-producing activity.
- It must have a determinable useful life.
- It must be expected to last more than one year.
- It must not be excepted property.
The following discussions provide information about these requirements.
Property You Own
To claim depreciation, you usually must be the owner of the property. You are considered as owning property even if it is subject to a debt.
Example 1. You made a down payment on rental property and assumed the previous owner's mortgage. You own the property and you can depreciate it.
Example 2. You bought a new van that you will use only for your courier business. You will be making payments on the van over the next 5 years. You own the van and you can depreciate it.
Leased property. You can depreciate leased property only if you retain the incidents of ownership in the property. This means you bear the burden of exhaustion of the capital investment in the property. Therefore, if you lease property from someone to use in your trade or business or for the production of income, you generally cannot depreciate its cost because you do not retain the incidents of ownership. You can, however, depreciate any capital improvements you make to the property. See How Do You Treat Improvements? later in this chapter and Additions and Improvements under Which Recovery Period Applies? in chapter 4.
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, 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, you cannot depreciate the cost of the property.
Incidents of ownership. Incidents of ownership in property 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.
Life tenant. Generally, if you hold business or investment property as a life tenant, you can depreciate it as if you were the absolute owner of the property. However, see Certain term interests in property under Excepted Property, later.
Cooperative apartments. If you are a tenant-stockholder in a cooperative housing corporation and use your cooperative apartment in your business or for the production of income, you can deduct depreciation for your stock in the corporation.
Figure your depreciation deduction as follows.
- Figure the depreciation for all the depreciable real property owned by the corporation. If you bought your cooperative stock after its first offering, figure the depreciable basis of this property as follows.
- Multiply your cost per share by the total number of outstanding shares.
- Add to the amount figured in (a) any mortgage debt on the property on the date you bought the stock.
- Subtract from the amount figured in (b) any mortgage debt that is not for the depreciable real property, such as the part for the land.
- Subtract from the amount figured in (1) any depreciation for space owned by the corporation that can be rented but cannot be lived in by tenant-stockholders.
- Divide the number of your shares of stock by the total number of shares outstanding, including any shares held by the corporation.
- Multiply the result of (2) by the percentage you figured in (3). This is your depreciation on the stock.
Your depreciation deduction for the year cannot be more than the part of your adjusted basis in the stock of the corporation that is allocable to your business or income-producing property.
Example. You figure your share of the cooperative housing corporation's depreciation to be $30,000. Your adjusted basis in the stock of the corporation is $50,000. You use one half of your apartment solely for business purposes. Your depreciation deduction for the stock for the year cannot be more than $25,000 (½ of $50,000).
Change to business use. If you change your cooperative apartment to business use, figure your allowable depreciation as explained earlier. The basis of all the depreciable real property owned by the cooperative housing corporation is the smaller of the following amounts.
- The fair market value of the property on the date you change your apartment to business use. This is considered to be the same as the corporation's adjusted basis minus straight line depreciation, unless this value is unrealistic.
- The corporation's adjusted basis in the property on that date. Do not subtract depreciation when figuring the corporation's adjusted basis.
If you bought the stock after its first offering, the corporation's adjusted basis in the property is the amount figured in (1), above. The fair market value of the property is considered to be the same as the corporation's adjusted basis figured in this way minus straight line depreciation, unless the value is unrealistic.
For a discussion of fair market value and adjusted basis, see Publication 551.
Property Used in Your Business or Income-Producing Activity
To claim depreciation on property, you must use it in your business or income-producing activity. If you use property to produce income (investment use), the income must be taxable. You cannot depreciate property that you use solely for personal activities.
Partial business or investment use. If you use property for business or investment purposes and for personal purposes, you can deduct depreciation based only on the business or investment use. For example, you cannot deduct depreciation on a car based on its use for commuting, personal shopping trips, family vacations, driving children to and from school, or similar activities.
You must keep records showing the business, investment, and personal use of your property. For more information on the records you must keep for listed property, such as a car, see What Records Must Be Kept? in chapter 5.
Although you can combine business and investment use of property when figuring depreciation deductions, do not treat investment use as qualified business use when determining whether the business-use requirement for listed property is met. For information about qualified business use of listed property, see What Is the Business-Use Requirement? in chapter 5.
Office in the home. If you use part of your home as an office, you may be able to deduct depreciation on that part based on its business use. For information about depreciating your home office, see Publication 587.
Inventory. You never can depreciate inventory because it is not held for use in your business. Inventory is any property you hold primarily for sale to customers in the ordinary course of your business. For more information, see Inventories in Publication 538.
In some cases, it is not clear whether property is held for sale (inventory) or for use in your business. If it is unclear, examine carefully all the facts in the operation of the particular business. The following example shows how a careful examination of the facts in two similar situations results in different conclusions. (Also, see Rent-to-own dealer under Which Property Class Applies Under GDS? in chapter 4.)
Example. Maple Corporation is in the business of leasing cars. At the end of their useful lives, when the cars are no longer profitable to lease, Maple sells them. Maple does not have a showroom, used car lot, or individuals to sell the cars. Instead, it sells them through wholesalers or by similar arrangements in which a dealer's profit is not intended or considered. Maple can depreciate the leased cars because the cars are not held primarily for sale to customers in the ordinary course of business, but are leased.
If Maple buys cars at wholesale prices, leases them for a short time, and then sells them at retail prices or in sales in which a dealer's profit is intended, the cars are treated as inventory and are not depreciable property. In this situation, the cars are held primarily for sale to customers in the ordinary course of business.
Containers. Generally, containers for the products you sell are part of inventory and you cannot depreciate them. However, you can depreciate containers used to ship your products if they have a life longer than one year and meet the following requirements.
- They qualify as property used in your business.
- Title to the containers does not pass to the buyer.
To determine if these requirements are met, consider the following questions.
- Does your sales contract, sales invoice, or other type of order acknowledgment indicate whether you have retained title?
- Does your invoice treat the containers as separate items?
- Do any of your records state your basis in the containers?
Property Having a Determinable Useful Life
To be depreciable, your property must have a determinable useful life. This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
Land. You never can 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.
Land preparation costs. Although you cannot depreciate land, you can depreciate certain costs (such as landscaping costs) incurred in preparing land for business use. These costs must be so closely associated with other depreciable property that you can determine a life for them along with the life of the associated property.
Example. You constructed a new building for use in your business and paid for grading, clearing, seeding, and planting bushes and trees. Some of the bushes and trees were planted right next to the building, while others were planted around the outer border of the lot. If you replace the building, you would have to destroy the bushes and trees right next to it. These bushes and trees are closely associated with the building, so they have a determinable useful life. Therefore, you can depreciate them. Add your other land preparation costs to the basis of your land because they have no determinable life and you cannot depreciate them.
Goodwill. You never can depreciate goodwill because its useful life cannot be determined. However, if you acquired a business after August 10, 1993 (after 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 chapter 9 in Publication 535.
Trademark or trade name. In general, a trademark or trade name does not have a determinable useful life and, therefore, you cannot depreciate its cost. However, you may be able to amortize its cost over 15 years if you acquired it after August 10, 1993 (after July 25, 1991, if elected). For more information, see chapter 9 in Publication 535.
Property Lasting More Than One Year
To be depreciable, property must have a useful life that extends substantially beyond the year you place it in service.
Example. You maintain a library for use in your profession. You can depreciate it. However, if you buy technical books, journals, or information services for use in your business that have a useful life of one year or less, you cannot depreciate them. Instead, you deduct their cost as a business expense.
Excepted Property
Even if the requirements explained in the preceding discussions are met, you cannot depreciate the following property.
- Property placed in service and disposed of in the same year.
- Equipment used to build capital improvements. You must add otherwise allowable depreciation on the equipment during the period of construction to the basis of your improvements. (See Uniform Capitalization Rules in Publication 551.)
- Section 197 intangibles.
- Certain term interests.
Section 197 intangibles. You cannot depreciate section 197 intangibles. Instead, you must amortize their cost over 15 years. For information, see chapter 9 in Publication 535.
Section 197 intangibles include the following types of property acquired after August 10, 1993 (after July 25, 1991, if elected).
- Franchises.
- Certain agreements not to compete.
- The following property, unless you created it other than in connection with the acquisition of assets constituting a business or a substantial part of a business.
- Patents and copyrights.
- Customer or subscription lists, location contracts, and insurance expirations.
- Designs, patterns, and formats, including certain computer software.
Computer software. Computer software is a section 197 intangible only if you acquired it in connection with the acquisition of assets constituting a business or a substantial part of a business. However, computer software is not a section 197 intangible and can be depreciated, even if acquired in connection with the acquisition of a business, if it meets all of the following tests.
- It is readily available for purchase by the general public.
- It is subject to a nonexclusive license.
- It has not been substantially modified.
Computer software includes all programs designed 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.
For information on how to depreciate software that is not a section 197 intangible, see Intangible Property under Can You Use MACRS To Depreciate your Property? later in this chapter.
If you lease computer software, see Leased property under Property You Own, earlier.
Certain term interests in property. You cannot depreciate a term interest in property created or acquired after July 27, 1989, for any period during which the remainder interest is held, directly or indirectly, by a person related to you.
Related persons. For a description of related persons, see Related persons in the discussion on property owned or used in 1986 under Can You Use MACRS To Depreciate Your Property? later in this chapter. For this purpose, however, treat as related persons only the relationships listed in items (1) through (10) of that discussion and substitute 50% for 10% each place it appears.
Basis adjustments. If you would be allowed a depreciation deduction for a term interest in property except that the holder of the remainder interest is related to you, you generally must reduce your basis in the term interest by any depreciation or amortization not allowed.
If you hold the remainder interest, you generally must increase your basis in that interest by the depreciation not allowed to the term interest holder. However, do not increase your basis for depreciation not allowed for periods during which either of the following situations applies.
- The term interest is held by an organization exempt from tax.
- The term interest is held by a nonresident alien individual or foreign corporation, and the income from the term interest is not effectively connected with the conduct of a trade or business in the United States.
Exceptions. The above rules do not apply to the holder of a term interest in property acquired by gift, bequest, or inheritance. They also do not apply to the holder of dividend rights that were separated from any stripped preferred stock if the rights were purchased after April 30, 1993, or to a person whose basis in the stock is determined by reference to the basis in the hands of the purchaser.
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