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Understanding Depreciation For Taxes

  Sanjiv Gupta CPA  Published 
Understanding Depreciation For Taxes

Depreciation is a market term used to signify the fall in the value of a commodity or a market in a bigger context. Generally, depreciation is observed over a period of time; and in a commercial aspect, it is used to represent the fall in the price of an asset over a fiscal year.

Depreciation is a method that allows an income tax deduction for the taxpayer in order to claim the cost based on a specific property. This acts as an annual allowance for devaluation, wear, and tear or uselessness of a property.

The properties that can be categorized as tangible property, furniture, buildings, machinery, vehicles and other equipment other than land, all these properties are depreciable. Similarly, patents, computer software programs and copyrights are also depreciable.

The Internal Revenue Service specifies properties that can be depreciated and how they can be depreciated. There are certain depreciation schedules for various types of assets as per the IRS. Referring to these schedules, you can know about the percentage of an asset’s value that you can deduct every year and for how many years. These depreciation deductions determine the asset’s recomputed basis when you sell the asset

You are required to use Form 4562, Depreciation and Amortization for reporting depreciation when filing a tax return. Form 4562 has six sections and you can get information on filling out each section by contacting your tax professional or searching online.

 Section 167

In the US law book, section 167 deals with a depreciation tax deduction of commodities. If you are purchasing a property that you are going to use in some form of business activity or to make money from it, it is possible that you fail to subtract the complete business expense in the same year of acquiring the property. You need to spread the cost over a fiscal year and then deduct part of the cost every year. This fall in the cost of business property is called depreciation.

 Repairs are immune to depreciation

Investments made on the property to increase its lifetime are immune to depreciation. If you are spending some more money on repairs and adding new things to the property to increase its usefulness, then you can slow down the rate of depreciation.

The procedure of depreciation

In order to depreciate, the investment property and other business matters should be placed for the Modified Accelerated Cost Recovery System (MARCS). This method allows a deduction for a larger amount during initial years and during later years, a lower amount of deductions are done and both are compared through straight-line methods.

Conditions required for allowing a depreciation tax deduction for any property

  • The legal taxpayer must be the owner of the property. Taxpayers also have the right to deduct tax regarding capital improvements for any property that he/she has taken on lease.
  • The property must be used by the taxpayer for business or any other activity that can produce income. In case of using any property for business and personal use, the taxpayer may reduce the depreciation depending upon the use of the property only for business purposes.
  • The property for which depreciation and tax deduction is applied must be useful for at least more than a year or two.

Under the following circumstances, a taxpayer cannot depreciate his or her property, in case of property being disposed of within the same year.  When equipment is used for building capital advancements, a taxpayer is only allowed to do so for equipment used during construction depending on the improvements. And certain terms and interests are also an issue.

Depreciation initiates only when the taxpayer provides the property for trade or for business, after using it for the production or as a source of income. When the taxpayer fully recovers the cost of the property, then the property becomes invalid for depreciation. Even if the taxpayer takes voluntary retirement from service, the above-mentioned scenario is applicable!

 Things to know for a proper depreciation tax deduction

  • Knowing the absolute method for depreciating your property.
  • Knowing your asset details well.
  • If the property falls under the listed property category.
  • If the taxpayer is electing for the expense for any part regarding the assets.
  • How depreciation is possible, based on the property.

179 deductions for deprecation

As per this section, one can deduct a cost for the limited account for a certain amount of depreciable property, only if you have placed it for service.  This kind of deduction is called section 179.  In 2013, the maximum amount that could be deducted was $500,000. However, higher limits are also applicable but it depends upon the asset.

The limitation is reduced depending upon the amount, and the cost of property offered for the service during the tax year goes above $2 million. Publication 946 clearly states about regulations and details about properties that are applicable for the deduction, its limitation, and how one can place the deduction at the right time.

Traditionally, the capital assets and their deduction is based upon the casual fact that vehicles, buildings, roads and similar improvements have a life for more than one year. But relying on the theory and facts, they get paid out of the savings brought together for several years.

The taxpayer should keep in mind that the land property does not fall under the category of depreciation, simply because it never wears out! The bookkeeping method is mainly used for reflecting the operations, which are an on-going procedure for the current year.  Specifically for this obvious reason, inflows about capital investments and depreciation are not reflected, same for income as well.

Should you take depreciation?

With the proper guidance and knowledge about depreciation tax deductions, one can save a good deal of money from tax. Several methods are available for calculating depreciation tax deductions based on the property. But it should be kept in mind that there are also some limitations to it. For example, when you sell an asset to earn profit and have made depreciation deductions on it, depreciation recapture is applied to impose a tax on the profit or gain from its sale. Since you have already benefitted from depreciation deduction from ordinary income, any gain you get, up to the depreciation sum, is required to be entered as ordinary income to make up for the previously made deduction.