How to Deduct Depreciation?

A taxpayer may be eligible for a deduction resulting from the deterioration or obsolescence of certain assets. Tangible property (including buildings, furniture, and equipment) is generally depreciable, as are intangibles like patents and software.

Depreciation allows a taxpayer to recover the investment cost of depreciable property through annual deductions over a set number of years. The depreciation count-down begins when the taxpayer starts using a depreciable asset in a business or for the production of income and stops when its basis is fully recovered (or the asset is taken out of service, if that happens first). A taxpayer can claim this using the Form 4562.

For property to be depreciable it should meet the following requirements:

  • The taxpayer must own the asset and it must be used in a business or other income-producing activity.
  • The asset must have a "useful life" of greater than one year.

Most property is depreciated using the Modified Accelerated Cost Recovery System (MACRS), which provides larger deductions in the early years of an asset's depreciation and smaller deductions in later years. A taxpayer using MACRS may be subject to alternative minimum tax (AMT).

Rental Property

The owner of rental property can take a depreciation deduction on the part of the property used for rental purposes. Someone who is not the owner but makes permanent improvements to leased property may be able to depreciate the improvements themselves. Land itself, however, cannot be depreciated.

A rental property's basis for depreciation is generally its adjusted basis as of the time it was first leased. If the property was used for personal purposes before becoming rental property, its basis for depreciation is the lesser of its adjusted basis or its fair market value as of the date on which its this change occurred.

The property's adjusted basis is generally:

  • the amount that the owner paid for the property (or value at receipt if received in exchange for services, other property, as a gift or inheritance, or from a spouse), not taking into account any land, plus certain fees, expenses, and taxes); plus
  • costs that could have been deducted but were capitalized; plus
  • the cost of certain additions or improvements; less
  • items representing return of cost, such as insurance, casualty losses not covered by insurance, some energy credits, and depreciation that was (or could have been) deducted.

In the 80's the rules changed for how taxpayers may treat depreciation on a rental property. For residential property placed in service after 1986, the owner generally must use MACRS. For property placed in service prior to this (but not prior to 1981) it should depreciated using the Accelerated Cost Recovery System (ACRS). Finally, if placed in service before 1981, the straight-line or declining balance method should be used.

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