How Does Depreciation Work?

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You may depreciate a truck used in a moving business, but not the movers.
You may depreciate a truck used in a moving business, but not the movers. (Image: David De Lossy/Photodisc/Getty Images)

Depreciation is the gradual decline in value of property used in a business. According to the federal tax code, a business can deduct depreciation from its gross income. In this way, part of the loss of value is recovered by a tax savings. It is vital for any business owner to understand how depreciation works and how to take advantage of the IRS allowance.

Qualified Property

Many different kinds of property are subject to depreciation. Machinery or electronic equipment, cars and trucks, office furniture and other goods used in business operation can be depreciated, as can intangible goods such as copyrights and patents, which have a limited lifespan. Land cannot be depreciated.

Tax Terms

In order to take the deduction, you must own the property outright. You cannot depreciate property that is rented or leased, as another business holds ownership of that property. However, if you make improvements to leased property, you may depreciate the expense. You must use the property to earn income and not for personal use. In addition, the property must be expected to last for at least a year.

Straight-Line Method

There are two basic methods for depreciating property, or accounting for its gradual fall in value. By the straight-line method, the value you depreciate is the same each year over the useful life of the property. You use the cost basis and deduct from that the salvage value. If you buy a printer that is expected to last seven years, costs $1,000, and is worth $300 as salvage, you may deduct one-seventh of its net value -- $700 -- each year. Each year you deduct $100.

Income-Forecast Method

The second method is known as the income-forecast method, which you can apply to copyrights, patents, books and other intangible or intellectual property. You calculate the original cost of the property and multiply that amount by a fraction made up of the annual net income, divided by the anticipated income for the next ten years. For example, your company may buy and produce a book. The cost is $100,000, and you expect the book to make $1 million over 10 years. However, the book does better than expected, and you make $200,000 net this year from sales. For tax purposes, you multiply $100,000 times $200,000/$1,000,000, arriving at a total depreciation amount of $20,000.

Forms

To report depreciation and take the tax deduction, you must use IRS Form 4562, Depreciation and Amortization. The form allows you to list all depreciated property and calculate the proper deduction amount.

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