What Depreciation Means and Why You Calculate It

Depreciation is the amount an asset loses in value each year as it ages and gets used. When you buy equipment, machinery, vehicles, or other business assets, they wear out or become outdated. Depreciation lets you account for that loss on paper, which reduces your taxable income and spreads the cost of an expensive purchase across multiple years instead of taking the whole hit in year one.

You calculate depreciation by dividing the cost of an asset by how many years you expect to use it, then recording that yearly amount as an expense. The IRS sets rules for how long different types of assets last — a car might depreciate over five years, while a building might take 27.5 years. The method you choose affects how much depreciation you record each year and when you record it.

Key Takeaways

  • Straight-line depreciation divides the asset cost evenly across its useful life and is the simplest method for most small businesses.
  • The IRS publishes recovery periods for different asset types, and you must use the period the IRS assigns, not one you choose yourself.
  • You need the asset's original cost, its salvage value (what you expect to sell it for at the end), and the number of years you will use it.
  • Accelerated methods like MACRS front-load depreciation into early years and are common for tax purposes but require more calculation steps.
  • You record depreciation as a non-cash expense on your income statement and reduce the asset's book value on your balance sheet.

Straight-Line Depreciation: The Standard Method

Straight-line depreciation is the most common approach because it is straightforward to calculate and understand. You take the cost of the asset minus its salvage value, divide by the number of years you will use it, and that is your annual depreciation expense.

The formula is: (Cost − Salvage Value) ÷ Useful Life in Years = Annual Depreciation Expense.

Example: You buy a delivery truck for $30,000. You expect to use it for five years and sell it for $5,000 at the end. The calculation is ($30,000 − $5,000) ÷ 5 = $5,000 per year. Each year for five years, you record $5,000 as a depreciation expense. After five years, the truck's book value on your balance sheet is $5,000, which matches what you expect to sell it for.

Salvage value is your best guess at what the asset will be worth when you no longer need it. If you are unsure, you can set it to zero — the IRS does not require you to estimate a salvage value for tax purposes, though accounting standards may differ depending on your industry.

IRS Recovery Periods and Asset Classes

The IRS does not let you decide how long an asset lasts. Instead, it publishes a list of asset classes and assigns each one a recovery period — the number of years over which you must depreciate it for tax purposes. Using the wrong recovery period can trigger an audit or require you to amend your return.

Common recovery periods include: vehicles and equipment (five years), office furniture and fixtures (seven years), land improvements like sidewalks and parking lots (15 years), and buildings (27.5 years for residential, 39 years for commercial). The IRS groups assets into these categories in Publication 946, which you can read from the IRS website at no cost.

If you are unsure which category your asset falls into, look up the asset type in Publication 946's table or ask your accountant. Using the wrong period means your depreciation deduction will not match what the IRS expects, and you may owe additional tax plus interest.

MACRS: The Accelerated Method for Tax Purposes

MACRS (Modified Accelerated Cost Recovery System) is the depreciation method the IRS requires for most business assets placed in service after 1986. Unlike straight-line depreciation, MACRS records more depreciation in the early years and less in later years, which reduces your taxable income faster.

MACRS uses two approaches: 200% declining balance (for most property) and 150% declining balance (for certain assets like farm equipment). The IRS publishes percentage tables for each recovery period and method. You multiply the asset's cost by the percentage for that year and recovery period, and that is your depreciation for that year.

Example: A $10,000 piece of equipment in the five-year class using 200% declining balance. Year one: $10,000 × 40% = $4,000. Year two: ($10,000 − $4,000) × 40% = $2,400. Year three: ($10,000 − $4,000 − $2,400) × 40% = $1,440. The percentages come from IRS tables and account for the switch to straight-line depreciation in later years.

MACRS is more complex than straight-line depreciation because you must look up the correct table and explore the right percentage each year. Most accounting software and tax software handle MACRS calculations automatically, so you enter the asset cost and recovery period and the software does the math.

Units of Production: Depreciation Based on Use

If an asset's wear depends more on how much you use it than on how much time passes, units of production depreciation may be more accurate. Instead of dividing cost by years, you divide cost by the total units the asset will produce or the total miles it will travel.

The formula is: (Cost − Salvage Value) ÷ Total Units Expected = Depreciation per Unit. Then multiply the depreciation per unit by the units produced or miles driven that year.

Example: A printing press costs $50,000 and is expected to print 500,000 pages before it wears out. Salvage value is $5,000. Depreciation per page is ($50,000 − $5,000) ÷ 500,000 = $0.09 per page. If the press prints 80,000 pages in year one, depreciation is 80,000 × $0.09 = $7,200. If it prints 60,000 pages in year two, depreciation is 60,000 × $0.09 = $5,400.

Units of production is common for vehicles (based on miles), manufacturing equipment (based on units produced), and machinery that runs intermittently. You must track actual usage, which requires more record-keeping than time-based methods.

Recording Depreciation in Your Books

Depreciation is a non-cash expense — you do not pay money when you record it. Instead, you make a journal entry that increases depreciation expense (which reduces profit on your income statement) and increases accumulated depreciation (which reduces the asset's value on your balance sheet).

The entry is: Debit Depreciation Expense, Credit Accumulated Depreciation. The accumulated depreciation account is a contra-asset account, meaning it offsets the asset account. On your balance sheet, you show the asset at its original cost, then subtract accumulated depreciation to show the book value.

Example: A truck cost $30,000. After one year of $5,000 annual depreciation, the balance sheet shows: Truck $30,000, less Accumulated Depreciation ($5,000), equals Book Value $25,000. After five years, accumulated depreciation is $25,000, so book value is $5,000.

You record depreciation at the end of each accounting period — usually monthly, quarterly, or annually depending on your business. Most accounting software lets you set up depreciation schedules so the entries post automatically each period.

Section 179 and Bonus Depreciation: Faster Write-Offs

Section 179 is an IRS rule that lets you deduct the full cost of certain assets in the year you buy them, instead of spreading the cost over several years. This is useful if you want to reduce taxable income quickly or if you expect lower profits in future years.

The Section 179 deduction limit changes each year — the IRS publishes the current limit in January. You can only use Section 179 for tangible property like equipment, machinery, and vehicles, not for buildings or land. You must use the property in your business more than 50% of the time.

Bonus depreciation is a separate rule that lets you deduct a percentage of the cost of new or used property in the year you place it in service. The percentage and rules change based on tax law changes, so check the IRS website or ask your accountant what applies to your purchase year.

If you claim Section 179 or bonus depreciation, you still depreciate any remaining cost using standard methods. These rules are optional — you can choose not to use them if you prefer to spread the deduction across multiple years.

Frequently Asked Questions

Can I change my depreciation method after I start using it?

You can change methods, but it requires IRS approval through Form 3115 (process for Change in Accounting Method). The IRS charges a user fee and may require you to adjust prior years' returns. It is better to choose the right method from the start. Talk to an accountant before you buy an asset if you are unsure which method to use.

What happens when I sell an asset before it is fully depreciated?

You record a gain or loss equal to the sale price minus the book value. If you sell the truck from the earlier example for $6,000 after three years (book value $15,000), you record a $9,000 loss. If you sell it for $18,000, you record a $3,000 gain. Gains and losses affect your taxable income that year.

Do I have to depreciate an asset, or can I deduct the whole cost at once?

For most assets, you must depreciate over time — the IRS does not let you deduct the full cost in year one unless you use Section 179 or bonus depreciation, and those have limits and rules. Land cannot be depreciated at all. Talk to your accountant about whether Section 179 makes sense for your purchase.

How do I handle depreciation if I buy an asset partway through the year?

Most methods assume you own the asset for a full year. If you buy it partway through, you depreciate it for the fraction of the year you own it. If you buy the truck in July (six months into the year), you record six months of depreciation in year one, then a full year in years two through five, then six months in year six. The IRS has specific rules for when assets are placed in service — check Publication 946 for details.

What is the difference between book depreciation and tax depreciation?

Book depreciation is what you record on your financial statements for your own records or for lenders. Tax depreciation is what you claim on your tax return. They can be different — you might use straight-line for book purposes and MACRS for tax purposes. The difference creates a deferred tax asset or liability on your balance sheet, which your accountant tracks.