Gavin Howe
Tax depreciation is the recovery of an asset's cost over a number of years, or the asset's useful life. Businesses are generally unable to deduct the full cost of a property in a single year and must instead deduct a part of the cost each year until they recover the full cost. This is known as depreciation expense. There are several methods for calculating depreciation expense, including straight-line, double-declining balance, units of production, and sum-of-the-years' digits. Businesses may also be able to take advantage of bonus depreciation, which allows them to immediately write off a percentage of an asset's cost. The availability and percentage of bonus depreciation are subject to change based on tax laws.
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What You'll Learn
Depreciation of rental property
Tax laws do not prescribe a depreciation expense each year. However, depreciation is a crucial concept in tax law, allowing rental property owners to recover the costs of their investment over time. This is because rental properties generate income over many years, and their costs should be allocated across those years.
Rental property depreciation is the process of deducting the cost of buying and/or improving a rental property over its useful life. This is done by spreading the cost of the property across several years, with a portion of the cost deducted annually until the full cost is recovered. This reflects the principle that the value of an asset gradually declines due to wear and tear, age, and obsolescence.
To be eligible for depreciation deductions, the IRS sets out specific criteria: the property owner must own the property outright, including if it is subject to a mortgage. Renters, lessees, and property managers do not qualify. The property must be used for business or income-producing activities, such as rentals. Personal residences or vacation homes used primarily by the owner are generally ineligible unless they meet strict rental use requirements. Additionally, the property must have one or more permanent structures, as land cannot be depreciated since it does not wear out.
The modified accelerated cost recovery system (MACRS) is a standard method for depreciating residential rental properties in the US. There are two variations: the general depreciation system (GDS) and the alternative depreciation system (ADS). GDS is the standard method, providing a 27.5-year recovery period for residential rental properties. It uses the straight-line depreciation method, resulting in consistent depreciation deductions each year. On the other hand, ADS offers accelerated depreciation methods, yielding larger deductions in the earlier years.
It is important to note that not all properties automatically qualify for depreciation. Even if a property meets the eligibility criteria, certain situations may arise where depreciation cannot be claimed. For instance, if you buy and sell rental property within the same year, you cannot claim depreciation for that year. Additionally, depreciation is only applicable to the building and certain land improvements, not the land itself.
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Bonus depreciation
The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, permanently restored 100% bonus depreciation for qualified assets placed in service on or after January 19, 2025. This provision incentivizes businesses to invest more, leading to higher productivity, increased jobs, and economic growth. Bonus depreciation is not applicable to buildings, although it does apply to certain qualified improvements.
Prior to the OBBBA, bonus depreciation was gradually phasing down from 100% to 0% by 2027. The new legislation reversed this phase-down schedule, making 100% bonus depreciation permanent. This change is especially advantageous for real estate investors, who can now fully deduct the cost of qualified property, including improvements, fixtures, and equipment, in the same tax year.
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Section 179 deductions
Section 179 of the Internal Revenue Code allows business taxpayers to deduct the cost of certain assets immediately instead of over time. This means that businesses can deduct the entire cost of qualifying property in the taxable year that the property is placed in service, rather than depreciating the property over several years. The types of assets that are eligible for Section 179 deductions include machinery, equipment, vehicles, computers, and off-the-shelf software. Some specific examples of eligible vehicles include cargo vans, SUVs over 6,000 lbs GVWR but under 14,000 lbs GVWR, and heavy work trucks.
There are dollar limits to the Section 179 deduction. For tax years beginning in 2024, the maximum Section 179 expense deduction is $1,220,000. This limit is reduced by the amount that the cost of Section 179 property placed in service during the tax year exceeds $3,050,000. The maximum Section 179 expense deduction for SUVs placed in service in tax years beginning in 2024 is $30,500. For 2025, the Section 179 deduction limit is $2,500,000, and for 2026, it increases to $4,000,000.
It is important to note that Section 179 deductions are subject to certain rules and restrictions. For example, if the percentage of business use of the property drops to 50% or less during the property's recovery period, the Section 179 deduction may need to be recaptured and included as ordinary income. Additionally, Section 179 deductions are generally not available for real estate, and land is never depreciable. However, buildings and certain land improvements may be depreciable.
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Depreciation of business assets
Depreciation is a standard accounting method that allows businesses to divide the upfront cost of physical assets over the number of years they expect to use them. It is a tax-deductible expense that helps businesses recover the cost of the property over a number of years. Depreciation is the recovery of the cost of the property over a number of years. Businesses can deduct a part of the cost every year until they fully recover its cost.
There are six general categories of non-real estate assets, each with a designated number of years over which assets in that category can be depreciated. The most common ones are three-year property (including tractors, certain manufacturing tools, and some livestock), five-year property (including computers, office equipment, cars, light trucks, and assets used in construction), and seven-year property (including office furniture, appliances, and property that hasn't been placed in another category). Land is not depreciable as it is considered to have an unlimited useful life, but buildings and certain land improvements may be.
Businesses can choose from several depreciation methods, including straight-line and accelerated options, depending on how they want to divide costs over an asset's useful life. Straight-line depreciation spreads the cost evenly across the asset's useful life, while accelerated depreciation includes methods that allocate higher depreciation costs in the earlier years of an asset's life, such as the double-declining balance and sum-of-the-year's digits.
For tax years beginning in 2024, the maximum Section 179 expense deduction is $1,220,000. This limit is reduced by the amount the cost of Section 179 property placed in service during the tax year exceeds $3,050,000. The special depreciation allowance is 60% for certain qualified property acquired after September 27, 2017, and placed in service after December 31, 2023, and before January 1, 2025.
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Depreciation methods
Straight-Line Depreciation
This is the most common and simplest method of calculating depreciation. In this method, the expense amount remains the same every year over the useful life of the asset. The formula for straight-line depreciation is:
> Straight-line depreciation = (Cost − Salvage value of the asset) / Useful life
For example, a company purchases a machine for $10,000 with a useful life of 5 years and a salvage value of $2,000. Using the straight-line method, the company will record a depreciation expense of $1,600 per year for 5 years.
Declining Balance Method
The declining balance method, also known as the reducing balance method, provides larger deductions in the early years of an asset's life. This method is useful for assets that lose value faster in the early years, such as technology. The formula for the declining balance method is:
> Declining balance depreciation = Beginning book value x Rate of depreciation
For example, if a company purchases a machine for $10,000 and decides to depreciate it using a depreciation rate of 20%, the annual depreciation expense would be $2,000.
Double-Declining Balance Method
The double-declining balance method is a variation of the declining balance method, providing even larger deductions in the early years of an asset's life. This method reflects the fact that assets typically lose more of their value in the first few years of their use. The formula for the double-declining balance method is:
> Double-declining balance depreciation = 2 x Beginning book value x Rate of depreciation
Using the previous example, if the company decides to use the double-declining balance method with a depreciation rate of 20%, the annual depreciation expense would be $4,000.
Sum-of-the-Years' Digits (SYD) Depreciation
The sum-of-the-years' digits method is an accelerated depreciation method, resulting in higher expenses in the early years and lower expenses in the later years of an asset's life. The formula for this method is:
> Depreciation Expense = (Remaining life / Sum of the years' digits) x (Cost – Salvage value)
For instance, for a piece of equipment with a cost of $25,000, an estimated useful life of 8 years, and a salvage value of $0, the depreciation expense would be calculated as follows:
> Depreciation Expense = (8 years / (1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 years)) x ($25,000 – $0) = $3,125
These are just a few examples of depreciation methods. Other methods include the units-of-production method and special depreciation allowances prescribed by tax laws, such as Section 179 deductions and bonus depreciation. The choice of method depends on various factors, and businesses can use different methods for different types of assets to optimize their tax strategies.
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Frequently asked questions
Tax depreciation is the depreciation expense that can be reported by a business for a given reporting period. It is the recovery of an asset's cost over a number of years.
While bonus depreciation and Section 179 are both immediate expense deductions, bonus depreciation allows taxpayers to deduct a percentage of an asset's cost upfront. In contrast, Section 179 allows taxpayers to deduct a set dollar amount.
Depreciable assets include machinery, equipment, buildings, vehicles, and furniture.
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