It’s a technical term, but understanding depreciation is a matter of understanding the following two concepts: Purchased assets you use to earn income can lose value over time for a variety of reasons. Using a mathematical formula, you can calculate the portion of value lost each year and deduct it from your income tax.
If you itemize as an employee, are self-employed, or have rental income, and if you buy property for your trade or business or for investment that has a useful (and calculable) life expectancy of greater than one year and that can be expected to wear out or become obsolete, you may claim a deduction by filing Form 4562. Report the deduction on line 22 of Schedule A (if the property is for the convenience of your employers), on Schedule C (if you're self-employed), or on Schedule E (for rental income). This property may be tangible (vehicles, equipment, tools, etc.), intangible (patent rights, copyrights, etc.), or real estate. Land itself, in spite of what we know about the rates of soil loss, can never be depreciated.
Reporting all the nuances of depreciation is an involved enough matter to merit a major article in itself, but here are a few of the basics. Most property is now depreciated by the Accelerated Cost Recovery System (ACRS) as either 3 year property (cars and light trucks), 5-year property (most tools and equipment) 10 year property (mobile homes and certain light-duty structures), or 18-year property (buildings). The specific percentages of the cost that may be recovered each year for each type of property are specified in the instructions for Form 4562. The full first year percentage may be taken for all but 18 year property, no matter when the item was put into service during the tax year. However, property depreciated under ACRS may not be claimed for a deduction in the year it's disposed of, no matter when during the year it's sold. ACRS is figured against your cost in the item, less 50% of any investment tax credit that you claim on the item.
Cars, computers, and (possibly) some other business items as yet unspecified by the IRS that are put into service after June 18, 1984, must be held at least 50% for business use in order to qualify for ACRS. Accurate, itemized daily logs of use are required! In addition, these items must be required for the convenience of the employer," and the IRS has decided that a letter from the employer isn't sufficient evidence. (Just what proof is sufficient hasn't been specified by the IRS yet, leaving taxpayers wondering just how to handle this matter.) In addition, for cars put into service after June 18, 1984, a $16,000 limit has been placed on the total amount that may be depreciated by ACRS. The amount in excess of $16,000 must be depreciated by one of several other methods. See IRS Publication 534 for more information.
Certain property may be "expensed" rather than depreciated under IRS Code Section 179. You may directly deduct up to $5,000 (the amount was frozen this year) for tangible business equipment put in service in 1984. The item must remain in business service for at least two years following the tax year; if the property is sold, the deduction must be recaptured as ordinary income. Selecting the expensing option prevents you from taking the investment tax credit or depreciation, so it generally doesn't result in as great tax benefits over the life of property, but it may be advantageous for those seeking an immediate large deduction.