Depreciation recovers the cost of business or rental property over time. Learn basis, MACRS, placed-in-service rules, examples and California differences.
Depreciation is a tax deduction that recovers the cost or other basis of qualifying business or income-producing property over time. Instead of deducting a capital asset's full cost as an ordinary expense when purchased, the taxpayer generally claims deductions over the asset's assigned recovery period.
Tax depreciation does not require an appraisal showing that the asset declined in market value. It follows statutory classifications, methods, conventions, elections, and limits.
Property generally must:
Equipment, furniture, computers, vehicles, machinery, buildings, and certain improvements can qualify. Land is not depreciable because it does not have a determinable useful life. Inventory and property held mainly for sale are generally recovered through cost of goods sold rather than depreciation.
Mixed-use property must be allocated between business or income-producing use and personal use. Listed-property and vehicle rules can impose additional substantiation and deduction limits.
Depreciation generally begins when property is placed in service — ready and available for its specifically assigned use. Payment date, delivery date, and placed-in-service date can be different.
A rental house is generally placed in service when it is ready and available for rent, not necessarily when the first tenant moves in. Equipment sitting uninstalled in a warehouse may not yet be ready for use. Depreciation ends when basis is fully recovered or the asset is retired from service, sold, exchanged, destroyed, or converted to personal use.
The core inputs are:
Most tangible property placed in service after 1986 uses the Modified Accelerated Cost Recovery System, or MACRS. The General Depreciation System commonly uses accelerated methods for personal property and straight-line treatment for real property. The Alternative Depreciation System applies in specified situations or by election.
Conventions determine how much of a year is treated as in service. Common conventions include half-year, mid-quarter, and mid-month.
Assume a landlord allocates $405,000 of basis to a residential rental building and $100,000 to land. Land is excluded. Residential rental property is generally depreciated over 27.5 years using straight line and the mid-month convention.
A rough full-year amount is:
$405,000 ÷ 27.5 = $14,727
The actual first and last years use the mid-month convention and depend on the placed-in-service month. Appliances, carpeting, landscaping, and improvements can have different class lives and placed-in-service dates, so they should not automatically be combined with the building.
Regular depreciation spreads recovery over time. Section 179 is an elective expense deduction for qualifying property, subject to a dollar limit, investment phaseout, taxable-business-income limit, and other restrictions. Bonus depreciation is an additional first-year deduction for qualifying property and generally applies by class unless the taxpayer elects out.
Federal law now generally provides permanent 100% bonus depreciation for qualifying property acquired after January 19, 2025. Section 179's federal limit for tax years beginning in 2026 is $2,560,000, reduced when qualifying property placed in service exceeds $4,090,000. Vehicle, business-use, entity, and other limits still apply.
Accelerating deductions is not automatically best. A taxpayer may prefer deductions in later higher-income years, need to preserve basis, face passive or at-risk limits, or receive little current state benefit. See Bonus Depreciation vs. Section 179 for a detailed comparison.
Form 4562 reports federal depreciation, Section 179, special depreciation allowance, listed property, and amortization. The resulting deduction can flow to Schedule C, Schedule E, Schedule F, Form 1065, Form 1120-S, Form 1120, or another return.
An asset schedule should track description, acquisition and service dates, original basis, business use, method, life, prior depreciation, current depreciation, and adjusted basis. Financial-statement book depreciation can differ from tax depreciation.
California does not conform to federal bonus depreciation and generally limits Section 179 to $25,000, with a $200,000 investment threshold. California also does not allow the Section 179 election for certain property federal law permits, including off-the-shelf software.
Differences are commonly calculated on form FTB 3885A for individuals and the corresponding depreciation form for an entity. Schedule CA (540 or 540NR) can reflect the adjustment. Because state depreciation may be lower initially, California adjusted basis can be higher than federal basis and later gain or depreciation can differ.
Depreciation reduces adjusted basis. The reduction can include depreciation that was allowed or allowable, even when the taxpayer failed to claim it. On sale, some gain can be treated as depreciation recapture or unrecaptured Section 1250 gain depending on the property and facts.
Missing depreciation should not simply be claimed as a large catch-up deduction without analysis. A change in accounting method and Form 3115 may be required.
Keep invoices, contracts, closing statements, allocation support, appraisals, improvement records, mileage and use logs, placed-in-service evidence, Forms 4562, federal and California depreciation schedules, prior returns, election statements, and sale documents.
Heath Income Tax can classify assets, maintain federal and California depreciation schedules, correct missing depreciation, and report purchases and dispositions with business or rental returns.
Is depreciation optional?
Some elections affect method or acceleration, but allowable depreciation generally reduces basis even if omitted.
Can land improvements be depreciated?
Certain improvements can be depreciable even though land itself is not. Classification depends on the improvement.
Does depreciation equal loan principal?
No. Debt repayment and tax cost recovery are separate.
Can depreciation create a rental loss?
Yes, but passive activity, at-risk, basis, and other limitations can suspend the loss.
The definitions and examples on this page are for informational purposes only and do not constitute tax advice. Tax laws change frequently and individual circumstances vary. Consult a qualified tax professional before making decisions based on this content.
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