Glossary of Tax Terms: Depreciation

There’s no easy way to explain depreciation, but here’s a try!

For tax purposes, depreciation is a deductible expense relating to the purchase of assets used in a business or rental activity. Assets are things that have a useful life of more than one year, so generally we’re talking about buildings and equipment.

Tax law does not allow for a full deduction right away for purchasing assets. Instead, the cost is spread out over the useful life of the asset. (Note: actually, tax law does allow for full deductions right away for purchasing assets if the taxpayer employs “bonus depreciation” or “Section 179 expensing.” But those are different topics for a different blog post.)

The IRS determines the useful life of an asset. For example, the IRS assigned a useful life of 5 years to computers. Meaning the purchase of a computer is deducted over 5 years. This is true even if a business only intends to use the computer for 3 years.

This concept is different from “generally accepted accounting principles” which govern financial statements. For GAAP purposes, an asset is depreciated over its useful life, and the company gets to determine that useful life. So in our computer example in the last paragraph, the depreciation deduction would be spread over 3 years for GAAP.

In practice, most of the small businesses I deal with use Section 179 expensing to deduct the full asset cost in the year of purchase. Or the business will take bonus depreciation. (Again, these two topics are another blog post for another day!) But sometimes Section 179 isn’t an option, and bonus depreciation may not result in 100% expensing right away, so it’s useful for business owners to have an understanding of depreciation.