The reason depreciation confuses most taxpayers is because the IRS and accountants use subtle technical language to describe it, even though most people do not understand the context of those details. While I am perfectly capable of using technical language, it doesn’t help my readers understand important tax concepts that directly affect their business.
The concept of depreciation comes from the matching principle in accounting. The matching principle simply says that when you are in business, the money you made should be “matched” to the expenses that you incurred to make that money.
Let’s use an example of a pizza delivery driver. She makes money from delivering pizzas, but she needs to use her car to make that money. Let’s see what happens when she makes $5,000 each year but must buy a car for $9,000 in the first year of business.
Accounting Without Matching Principal | |||
| Year 1 | Year 2 | Year 3 |
Revenue | $5,000 | $5,000 | $5,000 |
Expenses | $9,000 | $ - | $ - |
Profit | (-$4,000) | $5,000 | $5,000 |
Clearly, she took a huge loss in Year 1 but somehow had no expenses in Years 2 and 3. This doesn’t reflect how the car helped her earn money across all three years.
Accounting With Matching Principal | |||
| Year 1 | Year 2 | Year 3 |
Revenue | $5,000 | $5,000 | $5,000 |
Expenses | $3,000 | $3,000 | $3,000 |
Profit | $2,000 | $2,000 | $2,000 |
With the matching principle, our pizza delivery driver depreciated or “recovered the cost” of her car over three years, which led to an even $2,000 in profit per year. That makes much more sense considering she took in exactly $5,000 each year and had no other expenses except for the car. The matching principle is a product of the accrual method of accounting, which is considered more accurate and nuanced than the cash method of accounting. Regardless of which method of accounting you use in your business, the U.S. Congress made it law that depreciation be used in the calculation of tax owed. It’s that simple.
Depreciation requires businesses to gradually deduct an asset's cost over time rather than deducting it all at once in the year of purchase. Depreciation, in this context, does not mean that assets lose value over time. Assets such as real estate tend to increase in value over time, but they are still subject to depreciation rules when they are used in business. Depreciation is mandatory. It’s not optional. You need four pieces of information to calculate depreciation for an asset.
Cost Basis is the amount of money you spend to acquire an asset. It includes sales tax, shipping charges, installation fees, and other costs needed to start using it for business. Improvements are not added to the cost basis of an asset for the purpose of depreciation. They are depreciated as entirely separate assets.
Useful Life is the period of time the asset will theoretically provide economic benefits to its owner. It is set by IRS regulations for different categories of assets. Many assets survive well past their useful life. (Note: a business owner may use their own estimated useful life to depreciate assets on their books, which can differ from IRS-mandated useful life, which must be used for tax purposes.)
Date placed in service is the date an asset became ready and available for use in the business. Sometimes an asset is ready immediately upon purchase. Sometimes a personal asset is converted to business use, in which case, you will also need to know its fair market value (FMV) at the date of conversion.
Depreciation Method is the system used to allocate the expense. The tax rules are set by IRS regulations. The most common methods are called straight-line depreciation and double-declining balance. You have flexibility to use your own reasonable method of depreciation on your own books, but when you’re doing taxes, you need to follow IRS rules. There are also other types of depreciation in the tax code called Section 179 depreciation or bonus depreciation, but those two types of depreciation are beyond the scope of this article. We will be focusing on a system called the Modified Accelerated Cost Recovery System (MACRS) of depreciation.
The general formula for calculating straight-line depreciation is:
Annual Depreciation Expense = Cost Basis / Useful Life
For example, the useful life for an asset is 5 years. For simplification, let's say we will use the straight-line method of depreciation. Its cost basis is $44,783.
Annual Depreciation Expense = $44,783 / 5 = $8,957
After depreciating our asset, we need to subtract the accumulated depreciation from its basis to arrive at our new adjusted cost basis (AKA “book value”). In this case, $44,783 - $8,957 = $35,826. That is the simplified method of depreciation, but you know that the IRS doesn’t roll like that. If you’re brave enough, let’s use a more accurate example: depreciation for the Home Office Deduction! Our taxpayer bought a house on April 29, 2021 for $820,000. Here is the final settlement statement (equivalent to a receipt):
Purchase Price: $820,000.00
New Mortgage Loan
Interest $337.00
Loan Points $9,225.00
Property Taxes $846.70
Hazard Insurance $206.76
Appraisal Fee $675.00
Credit Report Fee $56.00
Home Inspection Fee $515.37
Termite Inspection Fee $471.20
Hazard Insurance $827.00
Notary Fee $200.00
HOA Transfer Fee $151.83
HOA New Owner Fee $45.00
HOA Dues $99.00
Prorated Costs
Property Taxes $349.97
HOA Dues $6.60
Escrow Fees $975.13
Title Charges
Owner’s Title Ins. $1,132.00
Lender’s Title Ins. $250.00
Recording Fees
Deed $86.00
Mortgage $36.00
Other Title Fees $104.71
TOTAL $835,865.27
Only the bolded costs are used in calculating the cost basis, which is $822,498. The IRS says in Publication 551:
Your basis includes the settlement fees and closing costs for buying property. You can't include in your basis the fees and costs for getting a loan on property. A fee for buying property is a cost that must be paid even if you bought the property for cash. Settlement costs don't include amounts placed in escrow for the future payment of items such as taxes and insurance.
The IRS also states, in detail, the exact type of costs that are nondeductible personal expenses such as home inspection fees. Fees that are associated with the ongoing use of property such as insurance and HOA dues are nondeductible. Mortgage points and real estate taxes may be itemized for a main home but are not used to calculate cost basis. If this property was being purchased for a business, then most of those costs can be deductible as ordinary and necessary business expenses. Now that we have the knowledge to calculate the cost basis of a home, and we have done so, let’s go back to depreciation.
The tax code says that we can only depreciate tangible business assets. If the example house is a personal use asset, then depreciation is irrelevant. But what if we use part of the house, such as a bedroom, as a home office for a small business or side gig? Then we need to determine the depreciable basis. Here’s how:
The depreciable basis of a personal asset converted to business use is the lesser of the following:
The adjusted cost basis on the date of conversion, or
The fair market value on the date of conversion.
For simplicity’s sake, we will assume the use of the home office started, or was placed in service, on the day the taxpayer acquired the asset on April 29, 2021. Therefore, we can use the adjusted cost basis of $822,498.
First, real estate consists of land and all the improvements thereupon (i.e., house, shed, fence, pool, etc.). Land does not lose its economic use over time. Therefore, land is not depreciated. So, the cost basis needs to be allocated, or divided, between land and improvements. The easiest way to find out is to examine the county property tax assessor’s report, but if you have a good case for believing that the assessor screwed up their analysis, you can always deviate from the report, within reason.
Let us assume that 55% of the value is allocated to the land, and 45% of the value is allocated to the improvements. We take $822,498 x 0.45 = $370,124, which is our depreciable basis.
Residential real estate assets have a useful life of 27.5 years, but our home office is going to be treated as a commercial-use asset, so we need to use the useful life for nonresidential real estate assets, which is 39 years. Now, $370,124 will be fully depreciated over 39 years. $370,124 / 39 = $9,490 is the annual depreciation amount per year for the entire asset, but we are not done yet.
We cannot depreciate personal-use assets, only business-use assets. So, we need to break that $9,490/year apart into business-use and personal-use. The easiest way to do that is to measure the area of your home office and divide it by the gross square footage of the home. Our example home office is a total of 153 sqft. Let’s say that the gross square footage of the entire home is 915 sqft. Then 153 / 915 = 0.16721. Our business-use percentage is 16.721%. Of the $9,490 we can depreciate each year, only $9,490 x 0.16721 = $1,587 is the amount we can deduct for depreciation each full year. Yes, I said “full” year. You knew that the tax code was not going to be that simple, right?
Introducing, depreciation convention.
In simple terms, depreciation convention is the set of rules that determines when and how you start and stop counting depreciation for a business asset within a tax year. It defines the part of the year the asset is considered to be in service, which impacts the first-year and final-year depreciation calculations. The three most common conventions are:
Half-Year (HY) convention
Mid-Quarter (MQ) convention
Mid-Month (MM) convention
An asset using the HY convention assumes that an asset is placed in service at the midpoint of the year and ignores the actual date. HY is the most common, and easiest, convention for depreciating most business assets.
MQ convention assumes that an asset is placed in service at the midpoint of whichever quarter it falls under.
MM convention assumes that an asset is placed in service in the middle of what ever month it is actually placed in service. The MM convention applies to real estate assets, so we will use this convention in our home office example.
Remember the date the home was purchased? April 29, 2021. You will also remember that the home office portion of the home was placed in service on the day it was purchased. Using the MM convention, we will treat the home office as being placed in service on April 15, 2021, exactly in the middle of the month. From the middle of April until the end of the tax year, the asset was in service for 8.5 months.
We need to prorate our full year’s worth of depreciation. $1,587 x (8.5 / 12) = $1,124 is the amount of depreciation we would take for the home office on our 2021 tax return. In 2022, we would take $1,587 depreciation, … and so on. In the final year, we would only be allowed to take 12 – 8.5 = 3.5 months of prorated depreciation before the full 39 years is up.
What if we add more home office space in another year? That’s easy! We know that the whole house can be depreciated by $9,490 if 100% of it was business use. If, in a future year, we convert another room in the house to use in the business, then we would recalculate our business use percentage. Let’s say our business use percentage was increased to 31.8% in 2025. Then we would take $9,490 x 0.318 = $3,018 in depreciation for 2025. Business use percentage can change, but what cannot change is the depreciable basis and the useful life.
Before, we leave off, I want to clarify one last thing that confused me for a long time. You will often read that when you make an improvement to an asset, you are supposed to add the cost of the improvement to your main asset’s basis. That implies that you are changing the depreciable basis of the main asset. No, you only add the cost of the improvement to the main asset’s basis for the purpose of calculating a gain or a loss when you sell it. If you make an addition to our example house, you would use the cost of the addition to calculate its own separate basis. If you used any part of the addition for business, then you would depreciate it separately from the main house. That’s right, improvements are treated as separate assets for the purpose of depreciation, even though you might sell them as one.
That may take some time to get used to, but when we used our example home office plus an addition, we actually “broke apart” the asset into more manageable pieces. The entire asset is composed of multiple parts, each with their own depreciation rules and parameters:
Real Estate Asset
Land
Improvements
Home Office Part
Personal Use Part
Addition
Business Use Part
Personal Use Part
We can always add on or take away from the main asset. If part or all of the house gets destroyed, we can write off the part(s) using something called a casualty deduction. A cost segregation analysis takes this concept to the extreme and pulls out parts that have shorter useful lives. I can easily add a photovoltaic (solar) system to the roof of our example house. Solar property has a useful life of 5 years, but if you take a tax credit for your solar system, you must subtract that from its depreciable basis. No double dipping!
A couple terms you might run into. There is a tax rule that says you must reduce an asset’s basis by the amount of depreciation allowed or allowable. Those two words have important legal meanings. “Allowed” is the depreciation you actually claim. "Allowable" means the depreciation you could have taken, regardless of whether you did or not. The IRS doesn’t give you deductions. They “allow” or “disallow” them. Tax deductions are a matter of legislative grace. The IRS just enforces the tax laws.
In conclusion, all of a business’s assets should be properly depreciated. Your Schedule of Depreciation should list each asset, its adjusted cost basis, useful life, current depreciation deduction for the year, along with all its depreciation allowed or allowable (accumulated depreciation) to date. This helps businesses keep track of their assets and helps with tax compliance. It can also lower your tax bill if you don't overlook depreciation, as many business owners do.
