The Basics of Depreciation

October 27, 2021
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Depreciation is a tax benefit that is often underutilized, misutilized or simply misunderstood by many American taxpayers and business owners. If you are thinking about making a significant purchase of property for personal and/or business use (car, real estate, computer, machinery or other equipment), it’s important to understand how depreciation works in conjunction with other tax deductions related to these purchases.

Business Use vs. Personal Use

The first thing to understand is that if you use the property solely for personal purposes, it is not tax deductible. You can’t write off the purchase or any depreciation that may occur over time.

However, if you use the property for business purposes, you can deduct some or all of the costs of ownership. It may depend on how much you use it for work. If it is being used primarily as a business asset, then you will be able to deduct the cost using regular depreciation, bonus depreciation or IRC Section 179 expensing.

Regular Depreciation vs. Bonus Depreciation

Regular depreciation takes three to 39 years, depending on the property involved. For example, a company car or work truck would depreciate at a faster rate than a commercial office building. Bonus depreciation, on the other hand, allows you to deduct 100 percent of the cost of personal property (if used for business purposes) in one year through 2022. Up to $1,050,000 of personal property may also be deducted in one year under IRC Section 179. Of course, it’s important to understand tax laws are always changing with each new administration, so you have to keep up with the current deduction options and rules for personal and/or business property expenses.

When Does Depreciation Start?

Depreciation won’t begin if you purchase the property with the intent of starting a new business. You must already be in business to claim eligible appreciation. You don’t have to actively be making sales or generating profits, as long as your business is a relevant concern for that tax year.

In addition, depreciation does not begin the moment you purchase property for your business. It only begins when you place the property “in service” for your business. You don’t have to actively use the property to consider it in service. However, the property must be available for use in your active business, which may occur after you have purchased the property.

What Are Depreciation Conventions?

If you are using regular depreciation, you must apply rules called “conventions” to determine the month in which your depreciation deduction begins. The earlier in the year your depreciation deduction starts, the larger tax deduction you will be able to make.

In most cases, the default rule is that regular depreciation for personal property begins July 1 of the first year the property is in service. If you purchase 40 percent or more of your personal property for the year during the fourth quarter, however, your depreciation begins at the midpoint of the quarter in which is is placed in service. This is known as the “mid-quarter convention.” First-year depreciation for real property (land, buildings, etc.) will begin at the middle of the month during which the property is placed in service—also known as “mid-month convention.”

Depreciation deductions can be complex, depending on the type of property, as well as how and when it is being used for your business. Whether you are getting a company car as an employee or you are purchasing real property and equipment for your own business, there are many tax laws and intricacies to understand. You will want to consult with your tax advisor and/or financial advisor to discuss your specific business expense and depreciation deduction options. Make sure you are doing things right to avoid audits and trouble with the IRS.

For all your tax planning, business planning and wealth management needs, contact Illumination Wealth today. Speak with one of our trusted financial advisors and learn more about how we can help you on the road to financial independence.