Depreciation is an accounting procedure that recognizes that certain types of property decline in value over time. This can be due to wear and tear or obsolescence. The Internal Revenue Service understands that you must eventually replace this property. Conceptually, depreciation is the process of deducting an amount of money from your income each year to compensate for the partial loss of value through wear and tear, obsolescence or other factors.
What Gets Depreciated
Tangible property used for the production of income generally depreciates over a number of years. Examples include buildings, vehicles, computers, machinery and tools. Intangible property can depreciate over time as well. Examples of depreciable intangible property include copyrights, patents and software. Land is not generally depreciable, though in some circumstances the owner can take a deduction for depletion of minerals.
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Your tax basis is the amount of after-tax money you have invested in a piece of property. It includes your purchase price and the cost of any capital investments you have made in the property. When you deduct a depreciation allowance from your income for tax purposes, you subtract the amount of your deduction from your tax basis in the property.
Why Depreciation Is an Expense
You treat depreciation as an expense because you experience a loss each year as your property declines in value. Depreciation allows you to adjust your balance sheet to reflect the loss you have taken over time and more closely reflect the value of your business. This is because depreciation gives you a more accurate sense of the true value of the assets in your business. If it weren't for depreciation, a business with a 35-year-old truck it plans to scrap next year would appear to have the same value as a brand new truck that it won't replace for years.
To depreciate property, you must actually place it in service, and use it for business purposes. However, if you occasionally use the property for personal reasons and other times for business purposes, you can take a partial deduction. Additionally, the property must have an expected life of at least one year.