Depreciation: Definition and How It Works in Tax and Accounting

Depreciation is the process of deducting the cost of a business asset over time rather than in the year it is purchased. For federal income tax purposes, depreciation is governed primarily by IRC §167 (general depreciation allowance) and IRC §168 (accelerated cost recovery system). Depreciation reflects the economic reality that physical assets — buildings, equipment, vehicles, furniture — wear out or become obsolete and lose value over time. By deducting depreciation annually, businesses reduce their taxable income during the period they are using the asset. For CPAs and their clients, depreciation is one of the most significant recurring deductions available, and its timing — accelerated vs. straight-line, bonus vs. regular — has material cash flow and tax planning implications.

MACRS: The Tax Depreciation System

For U.S. federal income tax purposes, most business assets are depreciated under the Modified Accelerated Cost Recovery System (MACRS), established by the Tax Reform Act of 1986 and codified at IRC §168. MACRS assigns each asset to a recovery class (defined by IRS Rev. Proc. 87-56 and asset class tables) and provides either accelerated or straight-line depreciation over that period:

Half-year convention: Most personal property uses the half-year convention — a half-year's depreciation is taken in the year of acquisition and the year of disposal, regardless of the actual purchase date. The mid-month convention applies to real property.

ADS (Alternative Depreciation System): Certain assets or taxpayers are required to use ADS (IRC §168(g)), which uses longer recovery periods and straight-line method. ADS is mandatory for listed property used 50% or less for business, property used predominantly outside the U.S., and in certain situations for real estate professional elections and QBI optimization.

Accelerated Depreciation: Bonus Depreciation and Section 179

Two provisions allow businesses to deduct asset costs far faster than standard MACRS:

Bonus Depreciation (IRC §168(k)): Under the One Big Beautiful Bill Act (OBBBA) of 2025, 100% bonus depreciation was restored for qualifying property placed in service after January 20, 2025. Bonus depreciation applies to new and used property with a MACRS recovery period of 20 years or less. Unlike Section 179, bonus depreciation has no annual dollar cap and can generate a net operating loss. For the full mechanics and current rules, see Bonus Depreciation.

Section 179 Expensing (IRC §179): Allows businesses to immediately expense the cost of qualifying business property rather than depreciating over its MACRS life. For 2026, OBBBA permanently raised the Section 179 limit to $2,560,000 with a phase-out threshold of $4,090,000. Unlike bonus depreciation, Section 179 cannot create or increase a net operating loss — it is limited to the business's taxable income from active trade or business. See Section 179 Deduction 2026 for complete 2026 rules.

Book Depreciation vs. Tax Depreciation

An important distinction for CPAs: financial accounting (GAAP) depreciation and tax depreciation are calculated differently and serve different purposes.

• GAAP depreciation uses estimated useful life and straight-line (or units of production) method under ASC 360, designed to match expense with revenue recognition
• Tax depreciation uses IRS-mandated MACRS recovery periods and accelerated methods, designed to incentivize investment

These differences create temporary book-tax differences that flow through a company's deferred tax asset/liability accounts. When clients take 100% bonus depreciation for a large equipment purchase, they may report near-zero taxable income while reporting book income — a common source of confusion that CPAs must explain to lenders and investors.

Depreciation Recapture

When a depreciated asset is sold, the IRS "recaptures" the tax benefit through additional income recognition:

• §1245 recapture: Applies to personal property (equipment, vehicles, machinery). All depreciation claimed is recaptured as ordinary income to the extent of the gain — not as capital gain. If a machine was purchased for $100,000, depreciated to $0, and sold for $60,000, the entire $60,000 is ordinary §1245 income.
• §1250 recapture: Applies to real property. For MACRS real estate (straight-line depreciation), only unrecaptured §1250 gain applies — taxed at a maximum 25% rate rather than ordinary income rates. For property depreciated faster than straight-line (historical ACRS property), the excess depreciation is recaptured as ordinary income.

Depreciation recapture is one of the most common surprises for clients selling real estate or equipment, and one of the most important planning topics CPAs address in advance of asset sales. See the Depreciation Recapture Guide for client advisory detail.

Listed Property Rules

Listed property (IRC §280F) — passenger automobiles, computers used outside a regular business establishment, certain entertainment property — is subject to special limitations:

• Luxury auto caps: Annual depreciation on passenger automobiles is capped even if bonus depreciation is claimed. For 2026, the first-year limit is approximately $12,400 (standard) or higher with bonus depreciation (IRS Rev. Proc. 2026 tables). Heavier SUVs over 6,000 lbs. GVWR avoid these caps but face a $32,000 Section 179 cap.
• Business-use percentage: Listed property used less than 50% for business must use ADS straight-line depreciation, not MACRS accelerated methods.

Related Terms

• Bonus Depreciation — IRC §168(k) first-year expensing, restored to 100% by OBBBA for property placed in service after January 20, 2025
• Net Operating Loss — bonus depreciation can generate an NOL when deductions exceed income; carryforward rules apply
• Capital Gains — depreciation recapture converts what might otherwise be capital gain into ordinary income at §1245 or §1250 rates
• Depreciation Recapture — how §1245 and §1250 recapture work at the time of sale, including Form 4797 reporting

How CPAs Use This in Practice

Depreciation planning is core to year-end tax strategy for any client with significant capital expenditures. The primary decisions: (1) use Section 179 first (capped, no NOL), then bonus depreciation for remaining qualifying property; (2) in high-income years, accelerate depreciation to shift income to lower-rate periods; (3) in low-income years (e.g., business startup, NOL years), consider electing out of bonus depreciation and using regular MACRS to preserve deductions for future high-income years. For year-end strategies involving depreciation, see Year-End Tax Strategies.