Understanding the Concept

• Tangible assets have a useful life -- a time period during which they function -- and then wear out. This is the underlying idea of depreciation. Buildings wear out, appliances wear out and carpets wear out. By providing you with an annual deduction that reflects this reduction in value, tax policy promotes investment into these kinds of assets.
  
  

What Qualifies

• For an asset to be depreciated, you must own it and use it to generate income. It must have a useful life of more than one year. And it cannot be land, because land does not wear out, according to the Internal Revenue Service. Most assets associated with a business you run or with rental property are depreciable. If you make an addition or improvement to rental property, you depreciate that asset separately. For instance, if you buy a building this year and replace its roof next year, the building will be depreciated beginning this year and the roof will be depreciated separately beginning next year.
  
  

Methods

• People tend to get a little lost when it comes to the methods of applying depreciation, because the rules and calculations can be complex. The IRS allows you to choose from two depreciation systems for property put into service after 1986: GDS (general depreciation system) and ADS (alternative depreciation system). Within the GDS, you have three styles of depreciation from which to choose: straight-line depreciation and two types of accelerated depreciation. Within ADS, you must use straight-line depreciation. In the straight-line method, the same depreciation figure is deducted as an expense every year over the asset's useful life. In the accelerated method, you take a greater deduction in the early years of ownership and a lower deduction in later years.
  
  

Useful Life

• The IRS classifies assets into useful life categories. It also lists the length of time over which assets in the various classes must be depreciated in each of the two depreciation systems. In the GDS system, a rental building is depreciated over 27.5 years. In the ADS system, it is depreciated over 40 years. Appliances and carpet are depreciated over five years in GDS; in the ADS system, they are depreciated over nine years.