Table of Contents
- Introduction
- Useful Items - You may want to see:
- What Property Can Be Depreciated?
- What Property Cannot Be Depreciated?
- When Does Depreciation Begin and End?
- What Method Can You Use To Depreciate Your Property?
- What Is the Basis of Your Depreciable Property?
- How Do You Treat Repairs and Improvements?
- Do You Have To File Form 4562?
- How Do You Correct Depreciation Deductions?
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 and answers the following questions.
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What property can be depreciated?
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What property cannot be depreciated?
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When does depreciation begin and end?
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What method can you use to depreciate your property?
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What is the basis of your depreciable property?
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How do you treat repairs and improvements?
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Do you have to file Form 4562?
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How do you correct depreciation deductions?
Publication
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534 Depreciating Property Placed in Service Before 1987
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535 Business Expenses
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538 Accounting Periods and Methods
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551 Basis of Assets
Form (and Instructions)
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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 6 for information about getting publications and forms.
Adjusted basis |
Basis |
Commuting |
Disposition |
Fair market value |
Intangible property |
Listed property |
Placed in service |
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.
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It must be property you own.
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It must be used in your business or income-producing activity.
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It must have a determinable useful life.
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It must be expected to last more than one year.
The following discussions provide information about these requirements.
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 to purchase 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.
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The legal title to the property.
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The legal obligation to pay for the property.
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The responsibility to pay maintenance and operating expenses.
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The duty to pay any taxes on the property.
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The risk of loss if the property is destroyed, condemned, or diminished in value through obsolescence or exhaustion.
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Figure the depreciation for all the depreciable real property owned by the corporation in which you have a proprietary lease or right of tenancy. If you bought your cooperative stock after its first offering, figure the depreciable basis of this property as follows.
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Multiply your cost per share by the total number of outstanding shares, including any shares held by the corporation.
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Add to the amount figured in (a) any mortgage debt on the property on the date you bought the stock.
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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.
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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.
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Divide the number of your shares of stock by the total number of outstanding shares, including any shares held by the corporation.
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Multiply the result of (2) by the percentage you figured in (3). This is your depreciation on the stock.
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).
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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.
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The corporation's adjusted basis in the property on that date. Do not subtract depreciation when figuring the corporation's adjusted basis.
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.
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chapter 4. 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.
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.
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They qualify as property used in your business.
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Title to the containers does not pass to the buyer.
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Does your sales contract, sales invoice, or other type of order acknowledgment indicate whether you have retained title?
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Does your invoice treat the containers as separate items?
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Do any of your records state your basis in the containers?
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.
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.
Amortization |
Basis |
Goodwill |
Intangible property |
Remainder interest |
Term interest |
Certain property cannot be depreciated. This includes land and certain excepted property.
You cannot 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.
Although you cannot depreciate land, you can depreciate certain land preparation 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.
Even if the requirements explained in the preceding discussions are met, you cannot depreciate the following property.
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Property placed in service and disposed of in the same year. Determining when property is placed in service is explained later.
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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.
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Section 197 intangibles. You must amortize these costs. Section 197 intangibles are discussed in detail in Chapter 8 of Publication 535. Intangible property, such as certain computer software, that is not section 197 intangible property, can be depreciated if it meets certain requirements. See Intangible Property on page 10.
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Certain term interests.
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The term interest is held by an organization exempt from tax.
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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.
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.
You place property in service when it is ready and available for a specific use, whether in a business activity, an income-producing activity, 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.
Donald Steep bought a machine for his business. The machine was delivered last year. However, it was not installed and operational until this year. It is considered placed in service this year. If the machine had been ready and available for use when it was delivered, it would be considered placed in service last year even if it was not actually used until this year.
Example 2.
On April 6, Sue Thorn bought a house to use as residential rental property. She made several repairs and had it ready for rent on July 5. At that time, she began to advertise it for rent in the local newspaper. The house is considered placed in service in July when it was ready and available for rent. She can begin to depreciate it in July.
Example 3.
James Elm is a building contractor who specializes in constructing office buildings. He bought a truck last year that had to be modified to lift materials to second-story levels. The installation of the lifting equipment was completed and James accepted delivery of the modified truck on January 10 of this year. The truck was placed in service on January 10, the date it was ready and available to perform the function for which it was bought.
Example.
You bought a home and used it as your personal home 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 begin to claim depreciation in the year you converted it to rental property because its use changed to an income-producing use at that time.
Continue to claim a deduction for depreciation on property used in your business or for the production of income even if it is temporarily idle (not in use). For example, if you stop using a machine because there is a temporary lack of a market for a product made with that machine, continue to deduct depreciation on the machine.
You stop depreciating property when you have fully recovered your cost or other basis. You recover your basis when your section 179 and allowed or allowable depreciation deductions equal your cost or investment in the property. See What Is the Basis of Your Depreciable Property, later.
You stop depreciating property when you retire it from service, even if you have not fully recovered its cost or other basis. You retire property from service when you permanently withdraw it from use in a trade or business or from use in the production of income because of any of the following events.
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You sell or exchange the property.
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You convert the property to personal use.
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You abandon the property.
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You transfer the property to a supplies or scrap account.
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The property is destroyed.
Adjusted basis |
Basis |
Convention |
Exchange |
Fiduciary |
Grantor |
Intangible property |
Nonresidential real property |
Placed in service |
Related persons |
Residential rental property |
Salvage value |
Section 1245 property |
Section 1250 property |
Standard mileage rate |
Straight line method |
Unit-of-production method |
Useful life |
You must use the Modified Accelerated Cost Recovery System (MACRS) to depreciate most property. MACRS is discussed in chapter 4.
You cannot use MACRS to depreciate the following property.
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Property you placed in service before 1987.
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Certain property owned or used in 1986.
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Intangible property.
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Films, video tapes, and recordings.
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Certain corporate or partnership property acquired in a nontaxable transfer.
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Property you elected to exclude from MACRS.
The following discussions describe the property listed above and explain what depreciation method should be used.
You cannot use MACRS for property you placed in service before 1987 (except property you placed in service after July 31, 1986, if MACRS was elected). Property placed in service before 1987 must be depreciated under the methods discussed in Publication 534.
For a discussion of when property is placed in service, see When Does Depreciation Begin and End, earlier.
You may not be able to use MACRS for property you acquired and placed in service after 1986 if any of the situations described below apply. If you cannot use MACRS, the property must be depreciated under the methods discussed in Publication 534.
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You or someone related to you owned or used the property in 1986.
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You acquired the property from a person who owned it in 1986 and as part of the transaction the user of the property did not change.
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You lease the property to a person (or someone related to this person) who owned or used the property in 1986.
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You acquired the property in a transaction in which:
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The user of the property did not change, and
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The property was not MACRS property in the hands of the person from whom you acquired it because of (2) or (3) above.
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You or someone related to you owned the property in 1986.
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You lease the property to a person who owned the property in 1986 (or someone related to that person).
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You acquired the property in a like-kind exchange, involuntary conversion, or repossession of property you or someone related to you owned in 1986. MACRS applies only to that part of your basis in the acquired property that represents cash paid or unlike property given up. It does not apply to the carried-over part of the basis.
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Residential rental property or nonresidential real property.
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Any property if, in the first tax year it is placed in service, the deduction under the Accelerated Cost Recovery System (ACRS) is more than the deduction under MACRS using the half-year convention. For information on how to figure depreciation under ACRS, see Publication 534.
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Property that was MACRS property in the hands of the person from whom you acquired it because of (2) above.
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An individual and a member of his or her family, including only a spouse, child, parent, brother, sister, half-brother, half-sister, ancestor, and lineal descendant.
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A corporation and an individual who directly or indirectly owns more than 10% of the value of the outstanding stock of that corporation.
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Two corporations that are members of the same controlled group.
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A trust fiduciary and a corporation if more than 10% of the value of the outstanding stock is directly or indirectly owned by or for the trust or grantor of the trust.
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The grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
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The fiduciaries of two different trusts, and the fiduciaries and beneficiaries of two different trusts, if the same person is the grantor of both trusts.
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A tax-exempt educational or charitable organization and any person (or, if that person is an individual, a member of that person's family) who directly or indirectly controls the organization.
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Two S corporations, and an S corporation and a regular corporation, if the same persons own more than 10% of the value of the outstanding stock of each corporation.
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A corporation and a partnership if the same persons own both of the following.
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More than 10% of the value of the outstanding stock of the corporation.
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More than 10% of the capital or profits interest in the partnership.
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The executor and beneficiary of any estate.
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A partnership and a person who directly or indirectly owns more than 10% of the capital or profits interest in the partnership.
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Two partnerships, if the same persons directly or indirectly own more than 10% of the capital or profits interest in each.
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The related person and a person who is engaged in trades or businesses under common control. See section 52(a) and 52(b) of the Internal Revenue Code.
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Stock or a partnership interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries. However, for a partnership interest owned by or for a C corporation, this applies only to shareholders who directly or indirectly own 5% or more of the value of the stock of the corporation.
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An individual is considered to own the stock or partnership interest directly or indirectly owned by or for the individual's family.
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An individual who owns, except by applying rule (2), any stock in a corporation is considered to own the stock directly or indirectly owned by or for the individual's partner.
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For purposes of rules (1), (2), or (3), stock or a partnership interest considered to be owned by a person under rule (1) is treated as actually owned by that person. However, stock or a partnership interest considered to be owned by an individual under rule (2) or (3) is not treated as owned by that individual for reapplying either rule (2) or (3) to make another person considered to be the owner of the same stock or partnership interest.
Generally, if you can depreciate intangible property, you usually use the straight line method of depreciation. However, you can choose to depreciate certain intangible property under the income forecast method (discussed later).
This method lets you deduct the same amount of depreciation each year over the useful life of the property. To figure your deduction, first determine the adjusted basis, salvage value, and estimated useful life of your property. Subtract the salvage value, if any, from the adjusted basis. The balance is the total depreciation you can take over the useful life of the property.
Divide the balance by the number of years in the useful life. This gives you your yearly depreciation deduction. Unless there is a big change in adjusted basis or useful life, this amount will stay the same throughout the time you depreciate the property. If, in the first year, you use the property for less than a full year, you must prorate your depreciation deduction for the number of months in use.
Example.
In April, Frank bought a patent for $5,100 that is not a section 197 intangible. He depreciates the patent under the straight line method, using a 17-year useful life and no salvage value. He divides the $5,100 basis by 17 years to get his $300 yearly depreciation deduction. He only used the patent for 9 months during the first year, so he multiplies $300 by 9/12 to get his deduction of $225 for the first year. Next year, Frank can deduct $300 for the full year.
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It is readily available for purchase by the general public.
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It is subject to a nonexclusive license.
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It has not been substantially modified.
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Any intangible asset acquired from another person.
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Created financial interests.
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Any intangible asset that has a useful life that can be estimated with reasonable accuracy.
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Any intangible asset that has an amortization period or limited useful life that is specifically prescribed or prohibited by the Code, regulations, or other published IRS guidance.
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Any amount paid to facilitate an acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions.
You can choose to use the income forecast method instead of the straight line method to depreciate the following depreciable intangibles.
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Motion picture films or video tapes.
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Sound recordings.
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Copyrights.
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Books.
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Patents.
Under the income forecast method, each year's depreciation deduction is equal to the cost, less salvage value, of the property, multiplied by a fraction. The numerator of the fraction is the current year's net income from the property, and the denominator is the total income anticipated from the property through the end of the 10th taxable year following the taxable year the property is placed in service. For more information, see section 167(g) of the Internal Revenue Code.
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Expenses that are qualified creative expenses under section 263A(h),
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Property to which a simplified procedure established under section 263A(i)(2) applies,
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Property that is an amortizable section 197 intangible, or
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Expenses that would not be allowable as a deduction.
MACRS does not apply to property used before 1987 and transferred after 1986 to a corporation or partnership (except property the transferor placed in service after July 31, 1986, if MACRS was elected) to the extent its basis is carried over from the property's adjusted basis in the transferor's hands. You must continue to use the same depreciation method as the transferor and figure depreciation as if the transfer had not occurred. However, if MACRS would otherwise apply, you can use it to depreciate the part of the property's basis that exceeds the carried-over basis.
The nontaxable transfers covered by this rule include the following.
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A distribution in complete liquidation of a subsidiary.
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A transfer to a corporation controlled by the transferor.
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An exchange of property solely for corporate stock or securities in a reorganization.
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A contribution of property to a partnership in exchange for a partnership interest.
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A partnership distribution of property to a partner.
If you can properly depreciate any property under a method not based on a term of years, such as the unit-of-production method, you can elect to exclude that property from MACRS. You make the election by reporting your depreciation for the property on line 15 in Part II of Form 4562 and attaching a statement as described in the instructions for Form 4562. You must make this election by the return due date (including extensions) for the tax year you place your property in service. However, if you timely filed your return for the year without making the election, you can still make the election by filing an amended return within six months of the due date of the return (excluding extensions). Attach the election to the amended return and write “Filed pursuant to section 301.9100-2” on the election statement. File the amended return at the same address you filed the original return.
Abstract fees |
Adjusted basis |
Basis |
Exchange |
Fair market value |
To figure your depreciation deduction, you must determine the basis of your property. To determine basis, you need to know the cost or other basis of your property.
The basis of property you buy is its cost plus amounts you paid for items such as sales tax (see Exception, below), freight charges, and installation and testing fees. The cost includes the amount you pay in cash, debt obligations, other property, or services.
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Legal and recording fees.
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Abstract fees.
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Survey charges.
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Owner's title insurance.
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Amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.
Other basis usually refers to basis that is determined by the way you received the property. For example, your basis is other than cost if you acquired the property in exchange for other property, as payment for services you performed, as a gift, or as an inheritance. If you acquired property in this or some other way, see Publication 551 to determine your basis.
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The fair market value (FMV) of the property on the date of the change in use.
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Your original cost or other basis adjusted as follows.
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Increased by the cost of any permanent improvements or additions and other costs that must be added to basis.
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Decreased by any deductions you claimed for casualty and theft losses and other items that reduced your basis.
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Example.
Several years ago, Nia paid $160,000 to have her home built on a lot that cost her $25,000. Before changing the property to rental use last year, she paid $20,000 for permanent improvements to the house and claimed a $2,000 casualty loss deduction for damage to the house. Land is not depreciable, so she includes only the cost of the house when figuring the basis for depreciation.
Nia's adjusted basis in the house when she changed its use was $178,000 ($160,000 + $20,000 - $2,000). On the same date, her property had an FMV of $180,000, of which $15,000 was for the land and $165,000 was for the house. The basis for depreciation on the house is the FMV on the date of change ($165,000), because it is less than her adjusted basis ($178,000).
To find your property's basis for depreciation, you may have to make certain adjustments (increases and decreases) to the basis of the property for events occurring between the time you acquired the property and the time you placed it in service. These events could include the following.
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Installing utility lines.
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Paying legal fees for perfecting the title.
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Settling zoning issues.
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Receiving rebates.
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Incurring a casualty or theft loss.
For a discussion of adjustments to the basis of your property, see Adjusted Basis in Publication 551.
If you depreciate your property under MACRS, you also may have to reduce your basis by certain deductions and credits with respect to the property. For more information, see What Is the Basis For Depreciation in chapter 4.
If you improve depreciable property, you must treat the improvement as separate depreciable property. Improvement means an addition to or partial replacement of property that adds to its value, appreciably lengthens the time you can use it, or adapts it to a different use.
You generally deduct the cost of repairing business property in the same way as any other business expense. However, if a repair or replacement increases the value of your property, makes it more useful, or lengthens its life, you must treat it as an improvement and depreciate it.
Example.
You repair a small section on one corner of the roof of a rental house. You deduct the cost of the repair as a rental expense. However, if you completely replace the roof, the new roof is an improvement because it increases the value and lengthens the life of the property. You depreciate the cost of the new roof.
Amortization |
Listed property |
Placed in service |
Standard mileage rate |
Use Form 4562 to figure your deduction for depreciation and amortization. Attach Form 4562 to your tax return for the current tax year if you are claiming any of the following items.
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A section 179 deduction for the current year or a section 179 carryover from a prior year. See chapter 2 for information on the section 179 deduction.
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Depreciation for property placed in service during the current year.
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Depreciation on any vehicle or other listed property, regardless of when it was placed in service. See chapter 5 for information on listed property.
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A deduction for any vehicle if the deduction is reported on a form other than Schedule C (Form 1040) or Schedule C-EZ (Form 1040).
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Amortization of costs if the current year is the first year of the amortization period.
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Depreciation or amortization on any asset on a corporate income tax return (other than Form 1120S, U.S. Income Tax Return for an S Corporation) regardless of when it was placed in service.
Table 1-1 presents an overview of the purpose of the various parts of Form 4562.
If you deducted an incorrect amount of depreciation in any year, you may be able to make a correction by filing an amended return for that year. See Filing an Amended Return, next. If you are not allowed to make the correction on an amended return, you may be able to change your accounting method to claim the correct amount of depreciation. See Changing Your Accounting Method, later.
You can file an amended return to correct the amount of depreciation claimed for any property in any of the following situations.
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You claimed the incorrect amount because of a mathematical error made in any year.
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You claimed the incorrect amount because of a posting error made in any year.
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You have not adopted a method of accounting for property placed in service by you in tax years ending after December 29, 2003.
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You claimed the incorrect amount on property placed in service by you in tax years ending before December 30, 2003.
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3 years from the date you filed your original return for the year in which you did not deduct the correct amount. A return filed before an unextended due date is considered filed on that due date.
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2 years from the time you paid your tax for that year.
Generally, you must get IRS approval to change your method of accounting. You generally must file Form 3115, Application for Change in Accounting Method, to request a change in your method of accounting for depreciation.
The following are examples of a change in method of accounting for depreciation.
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A change from an impermissible method of determining depreciation for depreciable property, if the impermissible method was used in two or more consecutively filed tax returns.
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A change in the treatment of an asset from nondepreciable to depreciable or vice versa.
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A change in the depreciation method, period of recovery, or convention of a depreciable asset.
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A change from not claiming to claiming the special depreciation allowance if you did not make the election to not claim any special allowance.
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A change from claiming a 50% special depreciation allowance to claiming a 30% special depreciation allowance for qualified property (including property that is included in a class of property for which you elected a 30% special allowance instead of a 50% special allowance).
Changes in depreciation that are not a change in method of accounting (and may only be made on an amended return) include the following.
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An adjustment in the useful life of a depreciable asset for which depreciation is determined under section 167.
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A change in use of an asset in the hands of the same taxpayer.
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Making a late depreciation election or revoking a timely valid depreciation election (including the election not to deduct the special depreciation allowance). If you elected not to claim any special allowance, a change from not claiming to claiming the special allowance is a revocation of the election and is not an accounting method change. Also, if the property is qualified property, a change from not claiming to claiming any special allowance is a late election and is not an accounting method change.
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Any change in the placed-in-service date of a depreciable asset.
See section 1.446-1(e)(2)(ii)(d) of the regulations for more information and examples.
Table 1-1. Purpose of Form 4562
This table describes the purpose of the various parts of Form 4562. For more information, see Form 4562 and its instructions.
Part | Purpose |
I |
• Electing the section 179 deduction
• Figuring the maximum section 179 deduction for the current year • Figuring any section 179 deduction carryover to the next year |
II |
• Reporting the special depreciation allowance for property (other than listed property)
placed in service during the tax year
• Reporting depreciation deductions on property being depreciated under any method other than Modified Accelerated Cost Recovery System (MACRS) |
III |
• Reporting MACRS depreciation deductions for property placed in service before this year
• Reporting MACRS depreciation deductions for property (other than listed property) placed in service during the current year |
IV | • Summarizing other parts |
V |
• Reporting the special depreciation allowance for automobiles and other listed property
• Reporting MACRS depreciation on automobiles and other listed property • Reporting the section 179 cost elected for automobiles and other listed property • Reporting information on the use of automobiles and other transportation vehicles |
VI | • Reporting amortization deductions |
Form 3115. If you file a Form 3115 and change from one permissible method to another permissible method, the section 481(a) adjustment is zero.
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