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  • Dennis C. Carroll, Esq.

How does depreciation work?


Instead of being able to take a current-year, full deduction for a business or income-producing purchase, some purchases require spreading (or depreciating) the cost over several years.


So, when you spend $1,200 on your cell-phone service each year, you can deduct (or expense) the full $1,200 that same year. Now ignoring the exceptions mentioned in this other post, when you spend $1,200 on a new cell-phone itself you must spread the $1,200 over the next 8 tax years, based on the IRS rules for that type of asset (with a "7-year recovery period"). Instead of a full deduction of the cost in one year, only a fraction of the cost is deducted each year.


During the first year that a cell-phone is used you can take a half-year's worth of a depreciation deduction. The deduction is calculated like this:


Year 1: $1,200 * (1/7) = $171 [1st year (*half-year) depreciation deduction]

Year 2: ($1,200 - $171) or $1,029 / (2/7) = $294 [2nd year depreciation deduction]

Year 3: ($1,029 - $294) or $735 / (2/7) = $210 [3rd year depreciation deduction]

Year 4: ($735 - $210) or $525 / (2/7) = $150 [4th year depreciation deduction]

Year 5: ($525 - $150) or $375 / (2/7) = $107 [5th year depreciation deduction]

Year 6: ($375 - $107) or $268 / (1/2.5) = $107 [6th year depreciation deduction]

In Year 6, we switch from the declining balance to the straight line method for a larger deduction.

Year 7: ($268 - $107) or $161 / (1/1.5) = $107 [7th year depreciation deduction]

Year 8: ($161 - $107) or $54 / (1/1) = $54 [8th year (*final year) depreciation deduction]


If you sell the cell phone, before the 8th year, then you may owe income tax on the gain. This gain is the difference between the sale price and the current basis of the cell phone.


Example:

Year 5:

Prior depreciation = 171 + 294 + 210 + 150 = 825

Final year depreciation = 54 [just like the above example]

Adjusted basis = 1,200 - 879 [all depreciation] = 321

Sale price = 500

Taxable gain = 500 - 321 = $179


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