What is tax depreciation?

Tax depreciation is the depreciation that can be listed as an expense on a tax return for a given time period under the applicable tax laws. Depreciation is the gradual charging to expense of an asset's cost over its useful life.

In the United States, you can only depreciate a cost if the situation meets all of the following five tests:

1. It is property the business owns
2. It is used in an income-producing activity
3. It must have a determinable useful life
4. You expect it to last more than one year
5. It cannot be certain types of property specifically excluded by the IRS

Otherwise, the cost must be charged to expense in its entirety when incurred.

Tax depreciation usually only varies from the depreciation allowed under the GAAP or IFRS accounting frameworks (known as "book" depreciation) in terms of the timing of the depreciation expense. Tax depreciation generally results in the more rapid recognition of depreciation expense than book depreciation in the United States, because tax depreciation uses MACRS, which is an accelerated form of depreciation. Under some circumstances, tax laws also allow the cost of some fixed assets to be charged entirely to expense as incurred.

Accelerated depreciation has the effect of reducing the amount of taxable income in the immediate future through increased expense recognition, and of increasing the amount of taxable income in later years. Given the time value of money, this means that tax depreciation in the United States is designed to reduce the net present value of taxes owed. Conversely, book depreciation is generally calculated on the straight-line basis, which gives a more even distribution of the expense over the life of the asset and usually gives a better representation of the actual decline in value of the asset over time.

Tax depreciation is based on a rigid set of rules that allow a certain amount of depreciation depending upon the asset classification assigned to an asset, irrespective of the actual usage or useful life of the asset. Conversely, book depreciation is more closely aligned with the actual usage of an asset.

In most cases, the total amount of allowable depreciation for tax depreciation and GAAP or IFRS depreciation will be the same over the total useful life of an asset.

Because of the calculation differences between tax depreciation and book depreciation, a company must maintain separate records for both types of depreciation. If you outsource tax preparation to an outside service, then the tax preparer will likely maintain the detailed tax depreciation records on your behalf.

Related Topics

Overview of depreciation
What is accelerated depreciation?
What is MACRS depreciation?
What is the purpose of depreciation?