Depreciation is the amount you can deduct annually to recover the cost or other basis of business property. This must be for property with a useful life of more than 1 year. You can depreciate tangible property except land.
Tangible property includes:
You can also depreciate the cost of improvements to tangible property if the improvement:
Adds to the value of the property
Significantly lengthens the time the property can be used
Adapts the property to a different use
However, you must deduct the cost of repairs to keep the property in a normal, efficient operating condition. You can't depreciate the property for this reason.
Use the modified accelerated cost recovery system (MACRS) to depreciate most of the property you place in service after 1986. Under MACRS, these 3 conventions determine when property is placed in service:
Half-year convention -- In most cases, the half-year convention is used for personal property. Personal property includes machinery, furniture, and equipment. Under the half-year convention, a half-year of depreciation is allowed in the first year of depreciation. This is regardless of when you actually placed the asset in service.
Mid-quarter convention -- You must use the mid-quarter convention instead of the half-year convention if both of these apply:
More than 40% of the assets were placed in service during the tax year.
Those 40% of assets were placed in service in the last 3 months of the year.
Under the mid-quarter convention:
Property is considered placed in service at the midpoint of a quarter. This is regardless of when it was actually placed in service during the quarter.
You'll be allowed to claim more than a half year's depreciation or less than a half year's depreciation. This will depend on which quarter of the year the property was placed in service.
Mid-month convention -- Real property, like buildings, is depreciated under the mid-month convention. The property is considered placed in service at the midpoint of the month. This is regardless of the actual date it was placed in service.
Ex: Tina, a ceramist, paid $1,200 for a potter's wheel, which she placed in service in January. She also paid $3,300 for a kiln, which she placed in service in November. Since the cost of the kiln is more than 40% of the total cost of property placed into service during the year, Tina must use the mid-quarter convention.
Section 179 Deduction
Under Section 179, you can claim a deduction in the current year by deducting all or a portion of the cost of certain property. You'd do this instead of depreciating the property.
You can claim the Section 179 deduction when you placed these types of property into service during the tax year:
Qualified tangible personal property
Qualified real property expenditures, which include:
Qualified leasehold improvement property
Qualified restaurant property
Qualified retail improvement property
Qualified Tangible Personal Property
For 2012, you can write off up to $500,000 of the cost of qualified tangible personal property. This deduction is phased out dollar-for-dollar if $2,000,000 or more of qualified tangible personal property is placed into service during the year.
Property that qualifies for the Section 179 deduction includes:
Tangible personal property, like:
Certain research and storage facilities
Single-purpose agricultural structures
Off-the-shelf computer software
Limitations on Section 179 Deduction
Your maximum Section 179 deduction can't be more than the taxable income you get from the active conduct of the trade or business. So, you must carry forward any excess Section 179 deduction. You'll do this until there's sufficient business income to allow the Section 179 deduction.
You might also be subject to the income limitation and have both types of expenses. If so, the current year deduction is allocated pro rata between each expense.
Ex: A business purchases a total of $300,000 Section 179 deduction-eligible property in 2012:
$100,000 worth of equipment
$200,000 in office furniture
The business has only $120,000 in taxable income for 2012.
The $120,000 Section 179 deduction is allocated pro rata between the equipment ($40,000) and the office furniture ($80,000). The remaining $180,000 is carried over to 2013 (assuming the business has sufficient taxable income) and is allocated:
$60,000 to the equipment
$120,000 to the office furniture
Increased Depreciation Deduction
Businesses located in these areas might qualify for an increased depreciation deduction:
Enterprise zone placed in service before Jan. 1, 2012
New York Liberty Zone placed in service before Jan. 1, 2010
These properties might also qualify for a special depreciation allowance:
Certain property with a long production period
Qualified Liberty Zone property placed in service before Jan. 1, 2010
Qualified GO Zone property placed in service before Dec. 31, 2011
Depreciation Rules for Listed Property
Special depreciation rules apply to listed property. Listed property includes:
Passenger automobiles and other property used for transportation. It excludes vehicles that aren’t likely to be used for personal purposes due to their nature or design, like
Other special-duty vehicles
Property usually used for entertainment, recreation, or amusement that isn't used exclusively at a regular place of business. This includes:
Computers not used exclusively at a regular place of business
Cell phones aren't listed property. You can deduct or depreciate cell phones under the regular rules for business property. You don't need detailed documentation on usage.
Listed property must be used continuously more than 50% of the time for business purposes. If you use the property less than 50% of time for business in the year you placed it in service, you can't claim a Section 179 deduction. Instead, you must depreciate the property using the alternative depreciation system (ADS). Under ADS, the straight-line method is used.
To learn more, see IRS Publication 946: How to Depreciate Property.