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Depreciation

A Brief Overview of Depreciation

Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.

Most types of tangible property (except, land), such as buildings, machinery, vehicles, furniture, and equipment are depreciable. Likewise, certain intangible property, such as patents, copyrights, and computer software is depreciable.

In order for a taxpayer to be allowed a depreciation deduction for a property, the property must meet all the following requirements:

The taxpayer must own the property. Taxpayers may also depreciate any capital improvements for property the taxpayer leases.
A taxpayer must use the property in business or in an income-producing activity. If a taxpayer uses a property for business and for personal purposes, the taxpayer can only deduct depreciation based only on the business use of that property.
The property must have a determinable useful life of more than one year.

Even if a taxpayer meets the preceding requirements for a property, a taxpayer cannot depreciate the following property:

Property placed in service and disposed of in same year.
Equipment used to build capital improvements. A taxpayer must add otherwise allowable depreciation on the equipment during the period of construction to the basis of the improvements.
Certain term interests.

Depreciation begins when a taxpayer places property in service for use in a trade or business or for the production of income. The property ceases to be depreciable when the taxpayer has fully recovered the property’s cost or other basis or when the taxpayer retires it from service, whichever happens first.

A taxpayer must identify several items to ensure the proper depreciation of a property, including:

The depreciation method for the property
The class life of the asset
Whether the property is “Listed Property”
Whether the taxpayer elects to expense any portion of the asset
Whether the taxpayer qualifies for any “bonus” first year depreciation
The depreciable basis of the property

The Modified Accelerated Cost Recovery System (MACRS) is the proper depreciation method for most property. Additional information about MACRS, and the other components of depreciation are in Publication 946, How to Depreciate Property .

A taxpayer must use Form 4562 , Depreciation and Amortization, to report depreciation on a tax return. Form 4562 is divided into six sections and the Instructions for Form 4562 contain information on how, and when to fill out each section.

You generally cannot deduct, in one year, the entire cost of property you purchased, either for use in your trade or business or to produce income, if the property has a useful life substantially beyond the tax year. Instead, you can depreciate it. That is, you can spread the cost over a number of years, and deduct a part of the cost each year. Instead of recovering the cost of the property by taking depreciation deductions, you can elect under Code section 179 to recover all or part of the cost of qualifying property, up to a limit, by deducting it in the year you place the qualifying property in service. For more information, refer to Publication 946 , How to Depreciate Property.

The kinds of property that you can depreciate include machinery, equipment, buildings, vehicles, and furniture. You cannot claim depreciation on property held for personal purposes. If you use property, such as a car, for both business or investment and personal purposes, only the business or investment use portion may be depreciated. You may depreciate property that meets all five of the following tests.

It must be property you own.
It must be used in a business or other income–producing activity.
It must have a determinable useful life.
It must be expected to last more than one year.
It must not be excepted property. Excepted property (as described in Publication 946, How to Depreciate Property) includes certain intangible property, certain term interests, and property placed in service and disposed of in the same year.

Generally, if you are depreciating property you placed in service before 1987, you must use the Accelerated Cost Recovery System (ACRS) or the same method you used in the past. For property placed in service after 1986, you generally must use the Modified Accelerated Cost Recovery System (MACRS).

For more information, refer to Publication 946 , How to Depreciate Property, or Publication 534 (PDF), Depreciating Property Placed in Service Before 1987. You can also find information on depreciation in Publication 527 , Residential Rental Property (Including Rental of Vacation Homes), Publication 463 , Travel, Entertainment, Gift, and Car Expenses, Publication 587 , Business Use of Your Home, and Publication 225 , Farmer's Tax Guide.

2009

Section 179 limits. The maximum section 179 expense deduction you can elect for qualified section 179 property you placed in service in tax years that begin in 2009 remains at $250,000 ($285,000 for qualified enterprise zone property and qualified renewal community property). This limit is reduced by the amount by which the cost of section 179 property placed in service in the tax year exceeds $800,000

Depreciation limits on business vehicles. The total depreciation deduction (including the section 179 expense deduction) you can take for a passenger automobile (that is not a truck or a van) you use in your business and first placed in service in 2009 is $2,960 ($10,960 for automobiles for which the special depreciation allowance applies). The maximum deduction you can take for a truck or van you use in your business and first placed in service in 2009 is $3,060 ($11,060 for trucks or vans for which the special depreciation allowance applies).

Beginning on Jan. 1, 2009, the standard mileage rates for the use of a car (also vans, pickups or panel trucks) will be:

55 cents per mile for business miles driven
24 cents per mile driven for medical or moving purposes
14 cents per mile driven in service of charitable organizations

Meal Expenses When Subject to "Hours of Service" Limits

In general, you can deduct only 50% of your business-related meal expenses. However, for 2008 and later years, you can deduct 80% of meal expenses while traveling away from your tax home for business purposes if the meals take place during or incident to any period subject to the Department of Transportation's "hours of service" limits. Business meal expenses are covered in chapter 1 of Publication 463 . Reimbursements for employee meal expenses are covered in chapter 11 of Publication 535

Self-Employment Tax

Who Must Pay SE Tax?

Generally, you must pay SE tax and file Schedule SE (Form 1040) if your net earnings from self-employment were $400 or more. Use Schedule SE to figure net earnings from self-employment.

Sole proprietor or independent contractor. If you are self-employed as a sole proprietor or independent contractor, you generally use Schedule C or C-EZ (Form 1040) to figure your earnings subject to SE tax.

SE tax rate. For 2011, the SE tax rate on net earnings is 13.3% (10.4% social security tax plus 2.9% Medicare tax).

Maximum earnings subject to self-employment tax. Only the first $106,800 of your combined wages, tips, and net earnings in 2011 is subject to any combination of the 10.4% social security part of SE tax, social security tax, or railroad retirement (tier 1) tax.

All of your combined wages, tips, and net earnings in 2011 are subject to any combination of the 2.9% Medicare part of SE tax, social security tax, or railroad retirement (tier 1) tax.

If your wages and tips are subject to either social security or railroad retirement (tier 1) tax, or both, and total at least $106,800, do not pay the 10.4% social security part of the SE tax on any of your net earnings. However, you must pay the 2.9% Medicare part of the SE tax on all your net earnings.

Special Rules and Exceptions

Aliens. Generally, resident aliens must pay self-employment tax under the same rules that apply to U.S. citizens. Nonresident aliens are not subject to SE tax unless an international social security agreement in effect determines that they are covered under the U.S. social security system. However, residents of the Virgin Islands, Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, or American Samoa are subject to self-employment tax, as they are considered U.S. residents for self-employment tax purposes. For more information on aliens, see Publication 519, U.S. Tax Guide for Aliens.

Child employed by parent. You are not subject to SE tax if you are under age 18 and you are working for your father or mother.

Church employee. If you work for a church or a qualified church-controlled organization (other than as a minister or member of a religious order) that elected an exemption from social security and Medicare taxes, you are subject to SE tax if you receive $108.28 or more in wages from the church or organization. For more information, see Publication 517, Social Security and Other Information for Members of the Clergy and Religious Workers.

Fishing crew member. If you are a member of the crew on a boat that catches fish or other water life, your earnings are subject to SE tax if all the following conditions apply.

You do not get any pay for the work except your share of the catch or a share of the proceeds from the sale of the catch, unless the pay meets all the following conditions.
1. The pay is not more than $100 per trip.
2. The pay is received only if there is a minimum catch.
3. The pay is solely for additional duties (such as mate, engineer, or cook) for which additional cash pay is traditional in the fishing industry.
You get a share of the catch or a share of the proceeds from the sale of the catch.
Your share depends on the amount of the catch.
The boat's operating crew normally numbers fewer than 10 individuals. (An operating crew is considered as normally made up of fewer than 10 if the average size of the crew on trips made during the last four calendar quarters is fewer than 10.)

Notary public. Fees you receive for services you perform as a notary public are reported on Schedule C or C-EZ but are not subject to self-employment tax (see the Instructions for Schedule SE (Form 1040)).

State or local government employee. You are subject to SE tax if you are an employee of a state or local government, are paid solely on a fee basis, and your services are not covered under a federal-state social security agreement.

Foreign government or international organization employee. You are subject to SE tax if both the following conditions are true.

You are a U.S. citizen employed in the United States, Puerto Rico, Guam, American Samoa, the Commonwealth of the Northern Mariana Islands, or the Virgin Islands by:
1. A foreign government,
2. A wholly-owned agency of a foreign government, or
3. An international organization.
Your employer is not required to withhold social security and Medicare taxes from your wages.

U.S. citizen or resident alien residing abroad. If you are a self-employed U.S. citizen or resident alien living outside the United States, in most cases you must pay SE tax. Do not reduce your foreign earnings from self-employment by your foreign earned income exclusion.

Exception. The United States has social security agreements with many countries to eliminate double taxation under two social security systems. Under these agreements, you generally must only pay social security and Medicare taxes to the country in which you live. The country to which you must pay the tax will issue a certificate which serves as proof of exemption from social security tax in the other country.

For more information, see the Instructions for Schedule SE (Form 1040).

How to Pay Self-Employment Tax

To pay SE tax, you must have a social security number (SSN) or an individual taxpayer identification number (ITIN). This section explains how to:

Obtain an SSN or ITIN
Pay your SE tax using estimated tax.

Obtaining a Social Security Number. If you never had an SSN, apply for one using Form SS-5, Application for a Social Security Card. You can get this form at any Social Security office or by calling (800) 772-1213. Download the form from the Social Security Online Web site.

Obtaining an Individual Taxpayer Identification Number. The IRS will issue you an ITIN if you are a nonresident or resident alien and you do not have and are not eligible to get an SSN. To apply for an ITIN , file Form W-7, Application for IRS Individual Taxpayer Identification Number.

Estimated Taxes

Federal income tax is a pay-as-you-go tax. You must pay the tax as you earn or receive income during the year. You generally have to make estimated tax payments if you expect to owe tax, including SE tax, of $1,000 or more when you file your return. There are two ways to pay as you go: withholding and estimated taxes. If you are a self-employed individual and do not have income tax withheld, you must make estimated tax payments .

Who Must Pay Self-Employment Tax?

You must pay SE tax and file Schedule SE (Form 1040) if either of the following applies.

Your net earnings from self-employment (excluding church employee income ) were $400 or more.
You had church employee income of $108.28 or more.

Your net earnings from self-employment are based on your earnings subject to SE tax. Most earnings from self-employment are subject to SE tax. Some earnings from employment (certain earnings that are not subject to social security and Medicare taxes) are subject to SE tax.

If you have earnings subject to SE tax, use Schedule SE to figure your net earnings form self-employment . Before you figure your net earnings, you generally need to figure your total earnings subject to SE tax.

Note: The SE tax rules apply no matter how old you are and even if you are already receiving social Security or Medicare.

Are You Self-Employed?

You are self-employed if any of the following apply to you.

You carry on a trade or business as a sole proprietor or an independent contractor.
You are a member of a partnership that carries on a trade or business.
You are otherwise in business for yourself.

Trade or business. A trade or business is generally an activity carried on for a livelihood or in good faith to make a profit. The facts and circumstances of each case determine whether or not an activity is a trade or business. The regularity of activities and transactions and the production of income are important elements. You do not need to actually make a profit to be in a trade or business as long as you have a profit motive. You do need, however, to make ongoing efforts to further the interests of your business.

Part-time business. You do not have to carry on regular full-time business activities to be self-employed. Having a part-time business in addition to your regular job or business also may be self-employment.

Example. You are employed full time as an engineer at the local plant. You fix televisions and radios during the weekends. You have your own shop, equipment, and tools. You get your customers from advertising and word-of-mouth. You are self-employed as the owner of a part-time repair shop.

Sole proprietor. You are a sole proprietor if you own an unincorporated business by yourself, in most cases. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation. For more information on this election and the tax treatment of a foreign LLC, see Form 8832, Entity Classification Election.

Independent contractor. People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors. However, whether these people are independent contractors or employees depends on the facts in each case. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to SE tax.

You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.

If an employer-employee relationship exists (regardless of what the relationship is called), you are not an independent contractor and your earnings are generally not subject to SE tax. However, your earnings as an employee may be subject to SE tax under other rules discussed in this section.

For more information on determining whether you are an independent contractor or an employee, refer to the section on Independent Contractors vs. Employees