The depreciation expense claimed by a taxpayer on a tax return to compensate for the loss in the value of the tangible assets used in income-generating activities
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Tax depreciation is the depreciation expense claimed by a taxpayer on a tax return to compensate for the loss in the value of the tangible assets used in income-generating activities. Similar to accounting depreciation, tax depreciation allocates depreciation expenses over multiple periods. Thus, the tax values of depreciable assets gradually decrease over their useful lives.
Tax authorities treat depreciation expenses as tax deductions. In other words, taxpayers can claim depreciation expenses for eligible tangible assets to reduce their taxable income and the tax amount owed.
What Assets are Eligible for Tax Depreciation?
Tax rules regarding depreciation can vary among different tax jurisdictions. Therefore, the assets eligible for a claim of tax depreciation expense may also vary among countries. Nevertheless, there are several key criteria for the assets to be considered eligible for depreciation claims that could be found across various jurisdictions:
A taxpayer owns the asset: A taxpayer can claim depreciation expenses only for those assets that are considered to be a property owned by a taxpayer.
The asset is used in the income-generating activities: A taxpayer can deduct depreciation expenses only for assets that are employed in the business or income-generating activities. Thus, assets that are intended solely for personal use are not eligible for the depreciation claim.
The asset has a determinable useful life: The asset eligible for depreciation claim must have a useful life that can be reasonably estimated. In other words, one can provide a reasonable estimate of the number of years during which the asset will remain in service until the point in time when it will become obsolete or will stop producing any economic benefits.
The asset’s useful life exceeds one year: Depreciation can be claimed only for long-term assets. It implies that the assets have a useful life of more than one year.
How is Tax Depreciation Calculated?
Generally, tax authorities (e.g., the Internal Revenue Service (IRS) in the United States) provide comprehensive guides to taxpayers on the rules applicable to the depreciation of tangible assets.
For example, the Canada Revenue Service (CRA), a federal tax agency in Canada, provides the guide on the Capital Cost Allowance (CCA). Essentially, CCA is a tax deduction associated with the depreciation of assets under Canadian tax laws.
The CRA divides all the assets eligible for CCA claim into different classes. Each asset class comes with its own depreciation rate and calculation method. For example, rental buildings are classified under Class 1 and must be depreciated at a 4% rate.
In the United States, the IRS publishes a guide on property depreciation that is similar to that of the CRA. In the IRS guide, a taxpayer may find all necessary information about property depreciation, including what assets are eligible for depreciation claim, as well as the applicable depreciation rates and useful lives.
Note that the depreciation expense recorded by a business on its financial statements may be different from the depreciation expense claimed on a tax return. The reason is that the methods applied to calculate depreciation expense for accounting and tax purposes do not always coincide. For example, accounting depreciation is commonly determined using the straight-line method, but tax depreciation is generally calculated via accumulated depreciation methods (e.g., double declining method). As a result, the depreciation calculation methods can vary significantly.
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