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Depreciation is an income tax deduction the Internal Revenue Service allows taxpayers to claim on certain types of property. The deduction is based on the gradual drop in value of some types of property throughout their useful life. Certain investments, such as buildings, machinery, vehicles, patents and computer software, may qualify as depreciable property. How you depreciate an eligible investment will vary depending on its value and the length of its useful life.
Although the rules determining the eligibility of depreciable property are complex, they boil down to three main requirements. You must own the property, it must either generate income or be part of your business and it must have a limited useful life of at least one year. Investments with an indefinite useful life, such as land or property you start using and get rid of in the same year, are not eligible. Intangible investments, such as franchises and goodwill, are not eligible either. However, certain intangible investments, such as patents and copyrights, which do have a set lifetime, are eligible for depreciation.
Modified Accelerated Cost Recovery System
The main deduction method is the Modified Accelerated Cost Recovery System, or MACRS. Under MACRS, taxpayers must claim their deductions by using set useful lives and methods depending on the property's class. For instance, the useful life of personal property ranges from three to 20 years, land improvements go from 15 to 20 years and residential property and business property may be depreciated over 27.5 and 40 years, respectively. Each class allows you to deduct a set percentage of the investment's initial value each year. The IRS provides a MACRS Percentage Table Guide in Appendix A of Publication 946 that details what depreciation percentage you can claim for each year in the life of an investment.
To calculate the deduction of an depreciable investment, you must multiply the item's basis by the percentage deduction set by the IRS for its class. For instance, furniture is part of a seven-year class that allows for a 10.71 depreciation for the first year and a 25.51 percent depreciation for the second year. If you paid $10,000 for a piece of furniture, you would be able to deduct $107 in the first year and $255 in the second year.
Straight Line Method
The straight line method is another depreciation method you can use, which in some cases -- particularly with intangible property -- allows you to claim a larger depreciation deduction. When calculating depreciation, use both the straight line method and the general MACRS method to determine which one offers the highest depreciation deduction. To calculate your depreciation deduction using the straight line method, first deduct from your investment's initial basis any previous depreciation deductions. Then, divide the current basis by the number of years left on the investment's useful life. The result is the depreciation deduction you can claim for the current year.
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