How Depreciation Affects Income Tax
We’ve used this term, but what is depreciation? Tax law recognizes that some things used in the production of income get used up or worn out over a period of yet, and allows you to deduct a portion of their acquisition price each year so you can set money aside tax-free to replace them after they’re used up. For example, if you buy a computer for business, the law assumes it will last five years, and so you can write off 1/5th of the purchase price each year. It also assumes you’ll set 1/5th of that purchase price aside each year so that , by the end of the 5th year, you’ll have all the money for a new computer saved up and ready to go.
Tax law acknowledges that buildings and other sorts of real property also get used up or worn out, although over a longer period of time. The allowable depreciation period for residential real estate is 27 1/2 years, and for non-residential real estate, it’s 39 years. Other sorts of real property can have different, and shorter, depreciation periods.
Like many other things in the tax code, depreciation is not a one-way street; it comes with consequences. One consequence of depreciation is that it lowers your basis, or tax cost, in your property. So, when it comes time to sell, any depreciation you’ve taken (or could have taken) over the years is subtracted from your basis, and so becomes part of your taxable profit on the sale. Another consequence is that not only is the depreciation taxable when you sell, but depreciation taken on real estate is subject to a special 25% tax rate, and is not eligible for the 15% capital gains rate. Additionally, any depreciation taken on a home office or a home rental after May 6, 1997 cannot be considered part of the $250,000 or $500,000 exclusion on profit on the sale of a principal residence.
Contact us at 323-257-5762 or at email@example.com with any questions you may have regarding depreciation. We are happy to help!