All business and rental real estate owners need certain assets to make their businesses possible. An asset can be anything from a car or a computer, to a piece of heavy-duty machinery or a rental house. Assets have a certain useful life and wear out over time. As a result, we need a way to match the cost of an asset to the income it produces. The IRS allows business owners to begin recovering the cost and claim the expense of an asset in the year it was purchased, or the year in which use of the asset began, on a tax return, and deduct some of the purchase price over time on a predetermined schedule of the asset’s useful life. This is called depreciation. Business and rental owners need to understand how depreciation affects their taxes each year, and how depreciation will affect their taxes when they sell their property or end their business.
Depreciation is the accounting method used to expense or deduct (in other words, match) the cost of any asset over the period of time the asset is expected to be used by the business. For taxes, the IRS has developed special methods for depreciation with different kinds of assets being assigned to specific categories and each category having a different number of years (useful life) for depreciating those assets. Some of these categories and useful life definitions are listed below. See IRS Publication 946 for the complete list.
- 5-year: Computers, cars, office equipment
- 7-year: Furniture, appliances, machinery, and heavy and agricultural equipment
- 10-year: Water transportation equipment, barns and greenhouses, some fruit bearing plants
- 15-year: Land and leasehold improvements
- 27.5-year: Residential rental (homes and apartments)
- 39-year: Commercial rental (buildings used for business)
For example, if you buy a delivery vehicle for your business and you choose to deduct actual vehicle expenses instead of using the IRS standard mileage allowance deduction, you will deduct a portion of the price you paid for the delivery vehicle each year for 5 years. If you keep the vehicle beyond 5 years, there will not be any more depreciation deduction available – although the expenses for driving the delivery vehicle will still be deductible each year. Same idea, but over a longer period time for rental real estate properties. The landlord will deduct a smaller portion of the cost basis (purchase price of the rental minus the value of land) for their building over a much longer period of 27.5 to 39 years, and after the building has been fully depreciated, they will not be able to deduct more depreciation on their property.
Often, an asset is sold when the business no longer needs it, even before it wears out or is fully depreciated. There are special situations and rules that allow for deducting the cost of an asset in the year it was bought, but these are the exception to the rule. Some business owners are eligible to deduct the full cost of an asset in the year it is purchased, but this is generally not allowed, and it may not be in the best interest of the business owner’s long term tax situation.
Depreciation has another trade off that other deductions do not have. Each year’s depreciation deduction accumulates and reduces the cost basis of the asset. This means that if you sell or trade-in your business asset, you may need to report taxable income on the transaction even if you sell the business asset for less than you originally paid.
For example, you bought the delivery van for $50,000 and used it for 7 years – fully depreciating the vehicle. You trade it in at the dealership for a new van and the dealer gives you a trade-in value of $10,000. On your tax return, you would report a taxable gain of $10,000 even though you paid $50,000 for the delivery vehicle. This situation is often called depreciation recapture – you are recapturing some of the prior depreciation deducted as income now that you sold the asset.
Depreciation recapture can make selling rental real estate especially costly for income taxes because the taxable gain from increased value when the asset is sold, is increased even more by recapturing the depreciation taken over the years that the property was used as rental real estate.
Unfortunately, there is no way to avoid depreciation recapture either. The IRS requires you to account for what they call the “allowed or allowable” depreciation when you report the gain or loss from the sale of business property. This means that the IRS will make you pay for depreciation recapture whether you deduct the expense or not.