Tax depreciation is the depreciation that can be listed as an expense on a tax return for a given reporting period under the applicable tax laws. It is used to reduce the amount of taxable income reported by a business. Depreciation is the gradual charging to expense of a fixed asset's cost over its useful life. In the United States, you can only depreciate an asset if the situation meets all of the following five tests:
- The asset is property the business owns
- The asset is used in an income-producing activity
- The asset must have a determinable useful life
- You expect it to last more than one year
- The asset cannot be certain types of property specifically excluded by the IRS
If these rules are not met, then a cost must be charged to expense in its entirety when incurred. From a tax deferral perspective, charging a cost to expense at once is not a bad thing - it reduces the amount of income in the near term on which income taxes must be paid.
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, so that the effective depreciation period is one tax year.
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 results in 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 an 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, and may even be assigned on an individual asset basis.
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, which means that the differences between book and tax depreciation are considered to be temporary differences.
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 behalf of the business.