Three Rules of Depreciation: Why, When, and What

If you use the property for personal purposes, it’s not deductible.

But if you use it in a business, you can deduct the full cost using:

• regular depreciation,
• bonus depreciation, or
• IRC Section 179 expensing.

Regular depreciation takes three to 39 years depending on the property involved, while bonus deprecation allows you to deduct 100 percent of the cost of personal property in one year through 2022. Up to $1,050,000 of personal property may also be deducted in one year under IRC Section 179.

Rule 1 of the Three Rules of Depreciation:

You Must Be in Business to Claim Depreciation

But depreciation won’t begin if you purchase property with the intent of beginning a new business.

You must actually be in business to claim depreciation. This doesn’t require that you make sales or earn profits—only that your business is a going concern.

A business begins for tax purposes when it starts to function as a going concern and performs the activities for which it was organized. Earning revenue isn’t necessarily required for a business to begin.

For example.  You begin a service business such as accounting, consulting, financial planning, law, medicine, or dentistry when you first offer your services to the public.

A retail business that sells tangible products to customers is when your business is ready to offer its product for sale to the public.

If you begin a manufacturing or other production-related business when it starts using its assets to produce saleable products. The products don’t have to be completed, nor do sales have to be solicited or made.

You begin a rental property business when you have the rental ready for occupancy.

If you buy an existing business, depreciation begins for tax purposes when the purchase is completed – that is, when you take ownership.

Rule 2 of the Three Rules of Depreciation:

Depreciation Begins When Property Is Placed in Service

Also, depreciation doesn’t begin the moment you purchase property for your business. It begins only when you place the property in service in your business. You don’t have to use the property to place it in service, but the property must be available for use in your active business. This could occur after you purchase the property.

Machinery

Machinery is placed in service when it is delivered and ready for use in your business. You don’t have to actually use it.

Example. Donald Steep bought a machine for his business. The machine was delivered last year. But it was not installed and operational until this year. Tax rules consider the machine to be placed in service this year.

If the machine had been ready and available for use when it was delivered, the IRS would consider the machine placed in service last year even though it was not actually used until this year.

Rental Property

A rental property is placed in service the day it is ready for occupancy and listed for rent. It doesn’t have to be rented.

Example. On April 6, Sue Thorn bought a house to use as a residential rental property. She made several repairs and had it ready for rent on July 5. At that time, she began to advertise it for rent in the local newspaper.

The house is considered placed in service in July when it was ready and available for rent. She can begin to depreciate it in July.

Vehicles 

A car or other vehicle is placed in service the moment it is ready for use in your business.

You don’t have to actually drive the car a single mile. (That said, we always recommend that you drive a vehicle at least one business mile to help prove that you placed it in service.)

Example. James Elm is a building contractor who specializes in constructing office buildings. He bought a truck last year that had to be modified to lift materials to second-story levels. The installation of the lifting equipment was completed, and James accepted delivery of the modified truck on January 10 of this year.

The truck was placed in service on January 10, the date it was ready and available to perform the function for which it was bought.

Rule 3 of the Three Rules of Depreciation: 

What Month of the Year Does Depreciation Begin?

Finally, if you use regular depreciation, you must apply rules called conventions to determine the month in which your depreciation deduction begins.

The earlier in the year, the larger your deduction for the first year.

If you use bonus depreciation or Section 179 expensing, you get a full deduction for the year you place the property in service, regardless of the month of the year, it was placed in service.

The default rule is that regular depreciation for the personal property begins July 1 the first year (mid-year convention). But if you purchase 40 percent or more of your total personal property for the year during the fourth quarter, your depreciation begins at the midpoint of the quarter in which it is placed in service (mid-quarter convention).

First-year depreciation for the real property begins at the middle of the month during which the property is placed in service (mid-month convention).

Takeaways

Here are five takeaways from this article:

1. Depreciation, including bonus depreciation, can’t begin until your business begins.
2. A business begins when it is functioning as a going concern—sales and revenue are not required.
3. Depreciation for business property purchased for an active business begins only when the property is placed in service in the business —in other words, it is available for use in the business.
4. First-year regular depreciation for the personal property begins either on July 1 (half-year convention) or at the midpoint of the quarter in which it is placed in service (mid-quarter convention).
5. First-year depreciation for real property depreciation begins at the middle of the month during which the property is placed in service (mid-month convention).

If you have any questions or need my assistance, please call me on my direct line at 509-543-7600 or send a request HERE.

November 2021

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