Originally published April 08, 2022
Small business owners often pay more in taxes than they need to.
Key Takeaways
- Depreciation is a tax deduction that reduces your taxable income, not your tax bill directly.
- It allows you to spread the cost of business assets over time instead of deducting everything at once.
- Most businesses use MACRS, which means the IRS determines how assets are depreciated.
- Section 179 and bonus depreciation can accelerate deductions, but they follow different rules and limits.
- Many assets qualify for depreciation, including equipment, vehicles, furniture, and some intangible property.
- You can still claim depreciation even if the asset was financed with a loan.
- Accurate records and proper classification are important to avoid errors and missed deductions.
- Many businesses miss out on depreciation simply because the rules feel complex or unclear.
Many avoid certain deductions because they worry about IRS scrutiny, or they miss opportunities simply because the rules feel complex.
You may be wondering,
How does depreciation affect taxes?
Depreciation allows businesses to deduct the cost of assets over time, reducing taxable income and the amount of tax owed.
At CMP, we work with small business owners daily, and one of our priorities is helping them minimize their tax burden. In this article, you will learn how it works and how much you can claim to reduce your tax liability.
What is Tax Depreciation?
The IRS defines depreciation as the recovery of property costs over time. Instead of deducting the full cost at once, you deduct a portion each year until the total cost is recovered.
In simple terms, tax depreciation allows you to spread the cost of a business asset over its useful life and deduct a portion each year to reduce your taxable income.
For example, if you purchase $20,000 in equipment and depreciate it over 5 years, you can deduct $4,000 each year. That means your taxable income is reduced by $4,000 annually, not just in the year you bought the asset.
This is where many business owners miss out. If you’ve purchased equipment, vehicles, or other business assets, you may already qualify for depreciation deductions without realizing it
IRS Depreciation Rules
As you would expect, the IRS has established specific rules for depreciation deductions. Before we explain how to deduct depreciation, let’s review those rules.
The rules dictate which types of property may be depreciated. To meet IRS requirements, the property must meet all of the following criteria:
- You must own the property: For depreciation, ownership applies even if you borrowed money to buy the property. For example, if you purchase a commercial vehicle with a loan, you can still depreciate it.
- It must be used in your business or another income-producing activity: The IRS allows assets used for both business and personal purposes. However, you may only deduct the percentage used for business. Property used only for personal purposes cannot be depreciated.
- It must last longer than one year: Depreciation is not intended for short-term or disposable items such as office supplies. Assets must have a useful life of more than 12 months to qualify, with some exceptions discussed below.
Common Depreciable Assets
According to IRS guidance, small business owners can depreciate most types of business property, including:
- Buildings and real property (excluding land)
- Equipment and machinery
- Office furniture
- Business vehicles
- Computers and technology
In addition to tangible assets, certain intangible assets may also be depreciated, including:
- Computer software
- Copyrights
- Patents
Exceptions to the Depreciation Rules
There are also specific cases where depreciation is not allowed:
- Property placed in service and disposed of within the same year may not be depreciated
- Equipment used to make capital improvements must be added to the basis of the improvement rather than deducted separately
- Certain intangible assets must be amortized under Section 197, including goodwill acquired as part of a business acquisition
- Property acquired from related parties may not qualify in certain situations
As depreciation rules are complex, the best option is to hire an experienced business accountant to help you properly depreciate your business property without attracting unwanted attention from the IRS.
Once you understand what qualifies, the next step is to see how depreciation actually impacts your taxes.
How Does Depreciation Affect Taxes?
Depreciation is beneficial to businesses because it allows them to reduce their taxable income.
In other words, claiming depreciation indirectly reduces your taxes because it lowers your taxable income. Depreciation does not directly reduce your tax bill because it is not a tax credit. Instead, it reduces the income amount used to calculate how much tax you owe.
Here’s how that works in practice.
If your business purchases $20,000 in equipment and depreciates it over 5 years using the straight-line method, you can deduct $4,000 each year.
That $4,000 deduction reduces your taxable income. So instead of paying taxes on your full income, you pay taxes on a lower amount.
For example, if your business is in a 25% tax bracket, a $4,000 depreciation deduction reduces your tax liability by $1,000 each year.
This is an important distinction.
- A tax deduction lowers your taxable income.
- A tax credit reduces your tax bill directly.
Depreciation is a deduction, not a credit. It saves you money by reducing the income that is taxed, not by directly reducing the taxes you owe.
Discovering how different types of income are taxed is crucial for understanding your tax obligations. If you found our guide on progressive tax codes informative, you won't want to miss our latest blog post, Breaking Down Income Types: How Each Is Taxed. In this comprehensive article, we delve into the various forms of income, such as earned income, investment income, rental earnings, and more. We explain how each type is taxed, providing clear examples and comparisons.
Is Depreciation Tax Deductible?
Yes, depreciation is a tax deduction. It reduces your taxable income, not your tax bill directly.
If your business earns $1 million and you claim $100,000 in depreciation, your taxable income is reduced to $900,000.
Unlike a tax credit, which reduces your tax bill directly, depreciation lowers the income that is taxed.
For example, if you owe $100,000 in taxes and qualify for $10,000 in tax credits, your final tax bill is reduced to $90,000.
If you want a deeper breakdown, you can read our guide on tax credits vs tax deductions.
Later in this post, we’ll explain how to calculate and claim depreciation for eligible assets.
What is the Special Depreciation Allowance?
The special depreciation allowance, often called bonus depreciation, has existed for years but was significantly expanded under the Tax Cuts and Jobs Act (TCJA) of 2017. Before the TCJA, businesses could generally deduct 50% of the cost of qualifying property in the first year it was placed in service.
The TCJA increased this allowance to 100%, allowing businesses to fully expense qualifying property in the year it was placed in service. This applies to depreciable property with a recovery period of 20 years or less, along with certain other types of property.
Common types of property that qualify include:
- Appliances
- Computers
- Equipment
- Office furniture
- Machinery
The 100% deduction applies to property placed in service after September 27, 2017, and before January 1, 2023. After that, the deduction began to phase down by 20% each year:
- 2023: 80%
- 2024: 60%
- 2025: 40%
- 2026: 20%
- 2027 and beyond: 0% (unless Congress enacts changes)
As of now, there is no confirmed permanent extension of the 100% bonus depreciation rules, although proposals to modify or extend them have been discussed. The One Big Beautiful Bill Act introduced changes worth reviewing with your tax professional to make sure your depreciation planning reflects current law.
Notably, used property may also qualify for bonus depreciation, provided it meets IRS requirements and was not previously used by the same taxpayer.
There are also special rules for self-constructed property where production began before September 28, 2017.
The purpose of bonus depreciation is to help businesses recover the cost of qualifying property more quickly, rather than spreading deductions over several years.
One important detail is that bonus depreciation is applied automatically. If you do not want to claim it, you must elect out. This election is made on a class-by-class basis, such as all 5-year property or all 7-year property.
CPA Insight:
Bonus depreciation is applied automatically, which means if you acquire qualifying property and do nothing, you're claiming it. If your business has a net operating loss or you expect significantly higher income in future years, opting out on a class-by-class basis and spreading the deduction out may actually put more money in your pocket over time. It's worth running the numbers before assuming the full deduction is always the right move.
How Is Depreciation Calculated for Tax Purposes?
In most cases, businesses do not freely choose a depreciation method. The IRS requires the use of the Modified Accelerated Cost Recovery System (MACRS) for most assets.
MACRS assigns a recovery period and depreciation method based on the type of asset. This means the IRS determines how long you depreciate an asset and which method applies. Most small businesses follow these schedules by default.
Suppose you elect not to claim 100% bonus depreciation in the year you acquire a depreciable asset. In that case, depreciation is calculated using one of several approved methods under MACRS or other applicable rules.
Straight-Line Method
The most commonly used method for calculating depreciation is the straight-line method. To use it, take the asset’s expected salvage value and subtract it from the asset’s cost. Then divide the result by the number of years you expect to use it.
Formula:
(Cost − Salvage Value) ÷ Useful Life = Annual Depreciation
Using the example from earlier:
($20,000 − $0) ÷ 5 = $4,000 per year
Unit of Production Method
For depreciable property whose value is tied more closely to usage than to time, the units-of-production method is useful. This typically applies to equipment or machinery where wear depends on how much it is used.
It allows businesses to claim more depreciation in years when the asset is heavily used and less in years when usage is lower.
Declining Balance Method
The declining balance method is used to accelerate depreciation. This means a larger portion of the asset’s cost is deducted in the early years.
This approach is often used for assets that lose value quickly, such as electronics or technology equipment.
Double-Declining
The double-declining method is a more aggressive version of accelerated depreciation. It applies a rate that is twice the straight-line rate, resulting in larger deductions in the early years and smaller deductions later.
This method is commonly used when assets become obsolete quickly.
Sum-of-the-Year's Digits
The sum-of-the-years' digits method is another accelerated depreciation method.
To calculate it, you add the digits of the asset’s useful life. For a 5-year asset, that would be:
5 + 4 + 3 + 2 + 1 = 15
In the first year, you depreciate 5/15 of the asset’s cost, which is about 33%. Each year after that, the fraction decreases.
This method allows you to front-load depreciation while still spreading it over the asset’s useful life.
Choosing the right method of depreciation will help you manage your tax liability more effectively when filing your federal return.
For a detailed calculation, you can use this depreciation calculator to compare methods for your assets.
How Much Depreciation Can You Write Off?
The TCJA increased bonus depreciation, but that’s not the only change it introduced. It also raised the limits for the Section 179 deduction and increased the phase-out thresholds.
Let’s look at the limits first. Before the TCJA, the Section 179 maximum deduction was capped at $500,000. The TCJA adjusted it upward, with annual inflation increases.
- 2019: $1,020,000
- 2020: $1,040,000
- 2021: $1,050,000
- 2022: $1,080,000
- 2023: $1,160,000
- 2024: $1,220,000
- 2025: $1,220,000 (subject to inflation adjustments; verify with current IRS guidance)
At the other end of the spectrum is the phase-out threshold. After a business exceeds this amount in total qualifying purchases, the Section 179 deduction is reduced dollar for dollar:
- 2019: $2,550,000
- 2020: $2,590,000
- 2021: $2,620,000
- 2022: $2,700,000
- 2023: $2,890,000
- 2024: $3,050,000
2025: $3,050,000 (subject to inflation adjustments; verify with current IRS guidance)
The Section 179 deduction limits and phase-out thresholds are now permanent parts of the tax code, subject to annual inflation adjustments.
In addition to Section 179, businesses may also claim bonus depreciation. Unlike Section 179, bonus depreciation does not have a dollar cap and is not limited by business income.
However, the TCJA phased out 100% bonus depreciation starting January 1, 2023:
- 80% for property placed in service in 2023
- 60% for property placed in service in 2024
- 40% for property placed in service in 2025
- 20% for property placed in service in 2026
How Section 179 and Bonus Depreciation Work Together
These two deductions are often used together.
Typically, businesses:
- Apply Section 179 first (up to the annual limit and income restriction)
- Then apply bonus depreciation to any remaining eligible asset cost
- Finally, use regular depreciation (MACRS) for any remaining balance
This approach allows businesses to maximize deductions in the year an asset is placed in service.
Section 179 vs. Bonus Depreciation
| Feature | Section 179 | Bonus Depreciation |
| Deduction limit | Up to $1,220,000 (2024 baseline, adjusted annually) | No dollar cap |
| Phase-out threshold | Starts at $3,050,000 (2024 baseline) | No phase-out |
| Asset types | New and used qualified property | New and used qualified property |
| Deduction timing | Year the asset is placed in service | Year the asset is placed in service |
| Income limitation | Cannot create a net loss | Can create a net loss |
| Current rate | Up to 100% within the limit | 40% (2025), 20% (2026) |
How to Claim Depreciation as a Tax Deduction
Claiming depreciation as a tax deduction involves a few key steps. While the rules can get technical, the overall process is straightforward.
Step 1: Confirm the asset qualifies
Make sure the asset meets IRS requirements. Your business must own it, used for business purposes, last more than one year, and have a determinable useful life.
Step 2: Determine the depreciation method
Most businesses use the Modified Accelerated Cost Recovery System (MACRS), which assigns a recovery period and method based on the type of asset. You can find full details in IRS Publication 946.
Step 3: Calculate your depreciation deduction
Use the appropriate method to calculate your annual deduction. This may include Section 179, bonus depreciation, or standard MACRS depreciation.
Step 4: Complete IRS Form 4562
Depreciation is reported using IRS Form 4562, which calculates your total deduction for the year.
Step 5: Report the deduction on your tax return
Where you report depreciation depends on your business structure:
- Sole proprietors and single-member LLCs report depreciation on Schedule C (Form 1040), typically in Part II
- C corporations (and LLCs taxed as C corporations) report depreciation on Form 1120
If you are dealing with older assets placed in service before 1987, different rules may apply under the Accelerated Cost Recovery System (ACRS), but this is uncommon for most current business assets.
For many business owners, depreciation can still feel complex. Working with a tax professional can help ensure everything is calculated correctly and reported in the right place.
CPA Insight:
One of the most common mistakes we see is businesses placing an asset in service on the wrong date. Depreciation starts when the asset is ready and available for use, not when you pay for it or when it's delivered. If equipment sits uninstalled at year-end, it doesn't qualify for that tax year. Keeping clear records of installation dates, not just purchase dates, protects your deduction if the IRS asks.
Frequently Asked Questions About Depreciation and Taxes
Here are answers to common questions business owners ask when deciding how and when to use depreciation.
When should a business start depreciating an asset?
You start depreciating an asset when it is placed in service, not when you purchase it. This means the asset must be ready and available for business use. For example, equipment that has been delivered but not yet installed usually does not qualify until it is operational.
Can you claim depreciation on used business equipment?
Yes, you can depreciate used equipment as long as it meets IRS requirements. The asset must be new to you and used for business purposes. Used property can also qualify for bonus depreciation if it meets eligibility rules.
What happens when you sell an asset that has been depreciated?
When you sell a depreciated asset, you may need to report depreciation recapture. This means part of the gain is taxed as ordinary income rather than capital gains. The exact tax treatment depends on the sale price and the asset’s adjusted basis.
Can you depreciate assets used partly for business and partly for personal use?
Yes, but you can only depreciate the business-use portion. For example, if you use a vehicle 60% for business, you can deduct 60% of the depreciation. Accurate records are important to support this allocation.
Is it better to take bonus depreciation or spread deductions over several years?
It depends on your situation. Bonus depreciation gives you a larger upfront deduction, which can reduce your taxes immediately. Spreading deductions over time may be more useful if you expect a higher income in future years.
Do you still claim depreciation if the asset was financed with a loan?
Yes, financing does not affect your ability to claim depreciation. You can depreciate the full cost of the asset, even if you paid for it with a loan. Loan payments and depreciation are treated separately for tax purposes.
What records should businesses keep to support depreciation deductions?
You should keep purchase receipts, invoices, and records showing when the asset was placed in service. It’s also important to document business use and depreciation calculations. These records help support your deduction if the IRS requests verification.
Don't Leave Money Behind: The Depreciation Deduction Can Help You Reduce Your Tax Bill
If you have purchased tangible property or qualified intangible assets for your business, the depreciation deduction can help lower your overall tax burden. The impact can be significant, especially when combined with options like Section 179 or bonus depreciation.
The challenge is that depreciation rules can be complex. Many business owners miss valuable deductions simply because they are unsure how the rules apply to their situation.
You may want professional guidance if you:
- Purchased large equipment or property
- Manage multiple assets with different depreciation schedules
- Need to decide between Section 179 and bonus depreciation
- Are you claiming depreciation for the first time
Working with a CPA who handles tax preparation, cost segregation, and bookkeeping and payroll can help you avoid errors, missed deductions, and filing issues that may lead to problems later.
If you want help reviewing your depreciation strategy or making sure you are claiming everything correctly, you can request a consultation.
