Accountants must ensure that the entities they serve are in compliance with GAAP and tax regulations. This serie of articles intends to bring some understanding on depreciation matters both from the accounting and tax perspectives.
The Internal Revenue Service (IRS - Publication 946 Chapter 10) defines depreciation as an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property.
To gain a better understanding of depreciation, it is necessary to know what property can be depreciated. Keep in mind that depreciation according to Generally Accepted Accounting Principles (GAAP) is usually different than the depreciation as per tax rules.
What Property Can Be Depreciated?
You can depreciate most types of tangible property (except land), such as buildings, machinery, vehicles, furniture, and equipment. You also can depreciate certain intangible property, such as patents, copyrights, and computer software.
To be depreciable, the property must meet all the following requirements.
· It must be property you own.
· It must be used in your business or income-producing activity.
· It must have a determinable useful life.
· It must be expected to last more than one year.
To clarify these concepts, here is a further discussion:
Property You Own
To claim depreciation, you usually must be the owner of the property. You are considered as owning property even if it is subject to a debt.For example,if you made a down payment to purchase rental property and assumed the previous owner's mortgage. You own the property and you can depreciate it.
Another example, you bought a new van that you will use only for your courier business. You will be making payments on the van over the next five years. You own the van and you can depreciate it.
Leased property. You can depreciate leased property only if you retain the incidents of ownership in the property. This means you bear the burden of exhaustion of the capital investment in the property. Therefore, if you lease property from someone to use in your trade or business or for the production of income, you generally cannot depreciate its cost because you do not retain the incidents of ownership. You can, however, depreciate any capital improvements you make to the property.
If you lease property to someone, you generally can depreciate its cost even if the lessee (the person leasing from you) has agreed to preserve, replace, renew, and maintain the property. However, if the lease provides that the lessee is to maintain the property and return to you the same property or its equivalent in value at the expiration of the lease in as good condition and value as when leased, you cannot depreciate the cost of the property.
Incidents of ownership.
Incidents of ownership in property include the following.
· The legal title to the property.
· The legal obligation to pay for the property.
· The responsibility to pay maintenance and operating expenses.
· The duty to pay any taxes on the property.
· The risk of loss if the property is destroyed, condemned, or diminished in value through obsolescence or exhaustion.
Life tenant. Generally, if you hold business or investment property as a life tenant, you can depreciate it as if you were the absolute owner of the property.
Cooperative apartments. If you are a tenant-stockholder in a cooperative housing corporation and use your cooperative apartment in your business or for the production of income, you can depreciate your stock in the corporation, even though the corporation owns the apartment.
Tax evasion is a crime because it looks for a reduction of tax liabilities by illegal means. Tax avoidance is a legal way of maximizing tax allowances that end in a decrease of the tax liability. Tax avoidance is a manner of tax planning perfectly recognized and encouraged by tax authorities.