Guide

What is depreciation? Methods, formulas, and examples

Learn how depreciation works, explore key methods, and see how it affects your taxes.

Published Tuesday 9 June 2026

Key takeaways

Depreciation spreads the cost of a tangible asset across its useful life, reducing your taxable income each year and giving a clearer picture of your finances.
The straight-line, declining balance, and units of production methods each suit different asset types; choosing the right one affects your financial statements and tax return.
For 2026, Section 179 lets you deduct up to $2,560,000 in qualifying asset costs, and bonus depreciation covers 100% of eligible purchases.
Tracking depreciation accurately on your income statement and balance sheet helps you make confident business decisions and stay compliant at tax time.

What is depreciation?

If you've ever bought equipment, a vehicle, or furniture for your business, you've likely encountered depreciation. Understanding how it works can save you money on taxes and help you plan your spending.

Depreciation is an accounting method that allocates the cost of a tangible asset over its useful life. Instead of recording the full cost as an expense in the year you buy it, you spread that cost across the years you expect to use it.

Every depreciable asset has a salvage value, also called residual value. This is the estimated worth of the asset at the end of its useful life. You subtract salvage value from the original cost before calculating depreciation.

The IRS requires businesses to report depreciation on Form 4562. You can find details on the IRS depreciation of property deduction page.

Depreciation applies only to tangible assets. Intangible assets, such as patents, trademarks, and copyrights, use a similar process called amortization. Both methods spread costs over time, but they apply to different types of property.

What can be depreciated?

Not everything you buy for your business qualifies for depreciation. The IRS sets specific rules about which assets you can depreciate and how long they last.

To qualify, an asset must be a fixed asset with a determinable useful life of more than one year. It must also be used in your business or held to produce income. Common depreciable assets include:

Tools, machinery, and manufacturing equipment
Computers, desks, and office furniture
Cars, trucks, and delivery vehicles
Buildings and structural improvements

Leased items may also qualify for depreciation if the lease agreement transfers ownership or meets certain IRS criteria. Check your lease terms to see if you're eligible.

Intangible assets follow a different path. You amortize items like patents, trademarks, and goodwill over their useful lives rather than depreciating them.

Some assets can't be depreciated at all. Land never loses its useful life, so it's excluded. Inventory is also excluded because it's meant for sale, not long-term use. For more on how inventory fits into your books, see this guide on inventory accounting.

Methods of calculating depreciation

There are several ways to calculate depreciation, and each method suits different situations. Your choice affects how much you deduct each year and how your financial statements look over time.

Straight-line depreciation

This is the simplest and most common method. It spreads the cost evenly across the asset's useful life.

The formula is: (Cost – Salvage Value) / Useful Life = Annual Depreciation

For example, if you buy a $5,000 machine with a $500 salvage value and a five-year useful life, you'd deduct $900 each year. This method works well for assets that lose value at a steady rate. Learn more about straight-line depreciation.

Declining balance depreciation

This method front-loads your depreciation deductions. You take larger deductions in the early years and smaller ones later.

The formula for double-declining balance is: Book Value x (2 / Useful Life) = Annual Depreciation

You apply this rate to the remaining book value each year, not the original cost. The deduction shrinks as the book value decreases. This method is useful for assets that lose most of their value quickly, like technology or vehicles.

Units of production depreciation

This method ties depreciation to actual usage rather than time. It works best for machinery or equipment where wear depends on output.

The formula is: ((Cost – Salvage Value) / Total Estimated Units) x Units Produced in Period = Depreciation for Period

If a machine can produce 100,000 units over its life, and it produces 15,000 units this year, you'd deduct 15% of the depreciable cost. This approach gives you a more accurate picture when usage varies from year to year.

Accelerated depreciation for tax purposes

The IRS offers accelerated options that let you deduct more in the early years. These can significantly reduce your tax bill when you buy qualifying assets.

The Modified Accelerated Cost Recovery System (MACRS) is the standard tax depreciation method in the United States. It assigns assets to specific property classes with predetermined recovery periods.

Section 179 lets you deduct the full cost of qualifying assets in the year you buy them, up to $2,560,000 for 2026. For SUVs, the deduction limit is $32,000. This is especially helpful if you're making large purchases for your business.

Bonus depreciation allows you to deduct 100% of the cost of eligible new or used assets in the first year for 2026, restored under the One Big Beautiful Bill Act. You can combine this with MACRS for the remaining balance. For full details, see IRS Publication 946.

How depreciation affects your financial statements and taxes

Depreciation doesn't just show up in one place. It flows through multiple financial documents and directly impacts your bottom line.

On your income statement, depreciation appears as an operating expense. It reduces your net income for the period, even though it's a non-cash charge. You can use an income statement template to see how this fits into your reporting.

On your balance sheet, accumulated depreciation reduces the book value of your assets over time. The original cost stays on the books, but the accumulated depreciation account grows each year. You can track this using a balance sheet template.

On your tax return, depreciation deductions lower your taxable income. This reduces the amount of tax you owe. Many small business owners report depreciation on Schedule C as part of their annual filing.

Choosing a depreciation schedule

Selecting the right depreciation schedule depends on your goals. The schedule you use for your books doesn't have to match the one you use for taxes.

Generally Accepted Accounting Principles (GAAP) give you flexibility to choose the method that best reflects how an asset loses value. The IRS, on the other hand, typically requires MACRS for tax purposes. You can review the relevant GAAP standard in FASB Statement No. 154.

Many businesses keep two separate depreciation schedules: one for financial reporting and one for taxes. This is perfectly normal and lets you optimize for both accurate reporting and tax savings.

When you dispose of, sell, or trade an asset, you'll need to update your records. If you sell an asset for more than its book value, you may owe tax on the gain. If you sell it for less, you can typically claim a loss.

How depreciation works: a practical example

Seeing the numbers in action makes depreciation easier to understand. Here are two examples using the same asset but different methods.

Suppose you buy a computer for $3,000 with no salvage value and a five-year useful life. Using straight-line depreciation, you'd deduct $600 each year. Here's how the book value changes:

Year 1: $600 depreciation, book value drops to $2,400
Year 2: $600 depreciation, book value drops to $1,800
Year 3: $600 depreciation, book value drops to $1,200
Year 4: $600 depreciation, book value drops to $600
Year 5: $600 depreciation, book value drops to $0

Now compare that with the double-declining balance method on the same $3,000 computer. The rate is 40% (2 / 5 years) applied to the remaining book value each year:

Year 1: $1,200 depreciation (40% of $3,000), book value drops to $1,800
Year 2: $720 depreciation (40% of $1,800), book value drops to $1,080
Year 3: $432 depreciation (40% of $1,080), book value drops to $648
Year 4: $259.20 depreciation (40% of $648), book value drops to $388.80
Year 5: $388.80 depreciation (remaining balance), book value drops to $0

The declining balance method gives you larger deductions in the first two years. This can be helpful if you want to offset higher income early on.

How to set up depreciation in your business

Getting depreciation right from the start saves time and avoids headaches at tax time. Follow these steps to set up a reliable system for your small business accounting.

Create a fixed asset register. List every depreciable asset you own, including the purchase date, cost, and expected useful life.
Assign a depreciation method. Choose straight-line, declining balance, or units of production for each asset based on how it loses value.
Determine salvage values. Estimate what each asset will be worth at the end of its useful life. This affects your annual deduction amount.
Record depreciation entries. At the end of each accounting period, record the depreciation expense in your books. This keeps your financial statements accurate.
Review and adjust annually. Check your estimates each year. If an asset's useful life or salvage value changes, update your calculations accordingly.

Using accounting software can automate much of this process. It tracks your assets, calculates depreciation, and posts the entries to your books automatically.

Simplify depreciation with Xero

Tracking depreciation across multiple assets and methods takes time. Xero's accounting software helps you manage fixed assets, automate depreciation calculations, and keep your books accurate without manual spreadsheets.

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FAQs on depreciation

Here are answers to frequently asked questions about depreciation.

Is depreciation good or bad?

Depreciation is a standard accounting practice, not something positive or negative. It gives you a more accurate view of your asset values and reduces your taxable income each year.

Why do businesses use depreciation?

Businesses use depreciation to match the cost of an asset with the revenue it helps produce. It also provides tax deductions that lower your annual tax bill.

What is the difference between depreciation and amortization?

Depreciation applies to tangible assets like equipment and vehicles. Amortization applies to intangible assets like patents and trademarks. Both spread costs over an asset's useful life.

What is accumulated depreciation?

Accumulated depreciation is the total amount of depreciation recorded against an asset since you started using it. It appears on your balance sheet and reduces the asset's book value.

How is depreciation calculated?

The most common method is straight-line: subtract the salvage value from the cost, then divide by the useful life. Other methods like declining balance and units of production adjust the timing of deductions.

What is depreciation on a car?

Car depreciation works the same way as other assets, but the IRS sets annual limits on how much you can deduct. For 2026, Section 179 caps SUV deductions at $32,000. Standard vehicles follow MACRS recovery periods.