When your business buys a computer, a delivery van, or a piece of equipment, that purchase usually helps you earn money for years. Depreciation is the way accounting and tax rules spread the cost of that purchase over the years you use it, instead of treating the whole amount as an expense on day one.
This guide explains what depreciation is, which assets qualify, how to calculate it with a simple example, and how to record it in your books. It also covers the tax-side tools you may hear about, such as MACRS and the Section 179 deduction.
What Is Depreciation?
Depreciation is the gradual spreading of an asset’s cost over the time you use it. The IRS describes it as an annual income tax deduction that lets you recover the cost of certain property over the time you use the property. It is an allowance for wear and tear, deterioration, or obsolescence.
Depreciation is also a non-cash expense. The cash leaves your bank account when you buy the asset. The depreciation entries that follow in later years do not move any money. They simply match a part of the asset’s cost to each period in which it helps produce revenue.
What Property Can Be Depreciated?
You can depreciate most tangible property except land, such as buildings, machinery, vehicles, furniture, and equipment. Certain intangible property, such as patents, copyrights, and computer software, can also be depreciated. To qualify, the IRS says the property must meet all four of these requirements:
- You own the property.
- You use it in your business or income-producing activity.
- It has a determinable useful life, which means it wears out, becomes obsolete, or loses value from natural causes.
- It is expected to last more than one year.
You can still depreciate an asset you are paying off. For example, a van you use only for your business is yours to depreciate even if you will be making payments on it for the next five years.
What You Cannot Depreciate
- Land. It does not wear out or get used up. Some land preparation costs that are closely tied to a depreciable asset can be depreciated.
- Inventory. It is held for sale, not for use in your business.
- Property used only for personal activities. If you use an item for both business and personal purposes, you can depreciate only the business-use part.
- Most leased property. If you lease property from someone else, you generally cannot depreciate its cost, but you can depreciate permanent improvements you make to it.
- Property placed in service and disposed of in the same year.
When Depreciation Starts and Stops
Depreciation begins when you place the property in service, which means it is ready and available for its specific use. A machine delivered in December but not installed until March is generally placed in service when it is ready and available for use, even if you have not used it yet.
Depreciation stops when you have fully recovered the asset’s cost or when you retire it from service, whichever comes first. You retire an asset when you sell it, convert it to personal use, abandon it, or it is destroyed. If an asset is temporarily idle, you keep depreciating it.
Repairs vs. Improvements
Not every cost tied to an asset is depreciated. Repairs that keep property in working order are generally deducted as ordinary business expenses in the year you pay for them. An improvement is different. If the work is a betterment, restores the property, or adapts it to a new use, you treat the cost as a separate depreciable asset.
The IRS gives a simple example. Repairing a small section of a roof is a repair, but replacing the whole roof is an improvement that you depreciate. If you are unsure which category a cost falls into, ask your accountant before you record it.
How to Calculate Straight-Line Depreciation
The straight-line method is the easiest way to understand depreciation. It deducts the same amount each year over the asset’s useful life. The formula is:
(Cost − Salvage Value) ÷ Useful Life = Annual Depreciation
Salvage value is what you expect the asset to be worth at the end of its useful life. Here is a hypothetical example. A business buys equipment for $6,000, expects it to last five years, and assumes no salvage value. The annual depreciation is $6,000 ÷ 5 = $1,200, or $100 per month.
| Year | Depreciation Expense | Accumulated Depreciation | Book Value at Year-End |
|---|---|---|---|
| 1 | $1,200 | $1,200 | $4,800 |
| 2 | $1,200 | $2,400 | $3,600 |
| 3 | $1,200 | $3,600 | $2,400 |
| 4 | $1,200 | $4,800 | $1,200 |
| 5 | $1,200 | $6,000 | $0 |
Book value is the asset’s cost minus accumulated depreciation. If the business had bought the equipment on July 1, the first-year expense would cover only six months, which is $600, and the remaining years would adjust accordingly.
How Tax Depreciation Works: MACRS
The straight-line example above shows the basic idea. On your federal tax return, however, the IRS requires you to use the Modified Accelerated Cost Recovery System (MACRS) for most property. MACRS assigns each type of property to a class with a set recovery period and uses specific conventions for the year the asset is placed in service.
Because of this, the depreciation you record in your books and the depreciation you claim on your tax return can differ. If you are not sure which method fits your situation, your accountant can set up the schedules for you. The full rules are in IRS Publication 946, which explains how to depreciate property, including recovery periods and the tables you use to figure each year’s deduction.
Section 179 and the Special Depreciation Allowance
Two tax rules let some businesses deduct more of an asset’s cost in the first year instead of spreading it out:
- Section 179 deduction. You can elect to deduct all or part of the cost of qualifying property in the year you place it in service. Qualifying property includes tangible personal property, such as machinery and equipment, and off-the-shelf computer software. The deduction is subject to a dollar limit and a business income limit, and the dollar limits change from year to year.
- Special depreciation allowance. This is an additional first-year deduction for certain qualified property. The percentage has changed in recent years because of new legislation, so check the current rules before you rely on it.
If you use an item for both business and personal purposes, you can elect Section 179 only when business use is more than 50%, and the deduction is based on the business-use portion of the cost. Property you buy from a related person or receive as a gift does not qualify. These elections affect your taxes in ways that carry into later years, so it is worth reviewing them with a tax professional before you decide.
How to Record Depreciation in Your Books
Depreciation is recorded with a journal entry. Using the $6,000 equipment example, the monthly entry is:
| Account | Debit | Credit |
|---|---|---|
| Depreciation Expense | $100 | |
| Accumulated Depreciation | $100 |
Depreciation Expense appears on your profit and loss statement. Accumulated Depreciation is a contra-asset account with a credit balance. It reduces the asset’s value on the balance sheet without changing the original cost. After one year, the balance sheet would show it like this:
| Equipment | Amount |
|---|---|
| Equipment, at cost | $6,000 |
| Less: Accumulated Depreciation | ($1,200) |
| Net Equipment (Book Value) | $4,800 |
Make sure your chart of accounts has both a Depreciation Expense account and an Accumulated Depreciation account for each major asset class. Many businesses post depreciation as part of their month-end closing routine so that every month’s profit reflects the cost of the assets in use.
Form 4562 and Records to Keep
The IRS uses Form 4562, Depreciation and Amortization, to report depreciation. You generally attach it to your return when you claim a Section 179 deduction, claim depreciation for property placed in service during the year, or claim depreciation on a vehicle or other listed property. Employees who deduct job-related vehicle expenses use a different form.
Keep the purchase invoice, the date you placed each asset in service, and records showing how much you use it for business and for personal purposes. Good records make depreciation schedules easy to prepare and easy to defend. For more on what to keep and for how long, see small business tax recordkeeping.
Common Depreciation Mistakes
- Depreciating land. Land is not depreciable.
- Starting too early. Depreciation begins when the asset is ready for use, not when you order or pay for it.
- Treating an improvement as a repair, or the reverse. The two are handled differently.
- Ignoring personal use. Only the business-use portion can be depreciated.
- Skipping depreciation you were entitled to take. The IRS says you must reduce an asset’s basis by the depreciation allowed or allowable, whichever is greater, even if you never claimed it.
Depreciation is one piece of the bigger picture of what a business can write off. For a broader look, read the guide to small business tax deductions.
Frequently Asked Questions
What is depreciation in simple terms?
Depreciation spreads the cost of a long-lasting business asset over the years you use it, so each year’s expenses reflect a fair share of the asset’s cost.
Is depreciation a cash expense?
No. You pay cash when you buy the asset. Depreciation entries in later periods do not move any money.
What is accumulated depreciation?
Accumulated depreciation is the total depreciation recorded on an asset since you placed it in service. It is shown as a deduction from the asset’s cost on the balance sheet.
Can I depreciate a vehicle I use for business?
You can depreciate the business-use portion of a vehicle. Vehicles are listed property with extra rules and recordkeeping requirements, so ask your tax professional how they apply to you.
Do I have to depreciate an asset, or can I deduct it all at once?
Some qualifying property can be deducted in the first year under Section 179, within limits. Otherwise, you depreciate the cost over the recovery period. A tax professional can help you choose between the options that apply to you.
Conclusion
Depreciation turns a big purchase into a series of smaller, predictable expenses that match the years the asset helps your business earn money. Know which assets qualify, record the entries every period, and keep the documents that support your schedule.
Start with a simple fixed asset list that shows each asset’s cost, in-service date, and useful life. From there, your accountant can match it to the tax rules, and your books will show the true value of what your business owns.