No. Inventory is not depreciable property under U.S. tax law. It’s treated as a short-term asset held for sale, not a long-term business asset, so you cannot write it off through depreciation. Instead, inventory costs get deducted through cost of goods sold (COGS) when you sell the goods.
For many business owners, the line between inventory and depreciable assets is a source of confusion. According to a 2022 National Small Business Association survey, 90% of small businesses say federal taxes impact their daily operations, and 1 in 3 cite tax complexity as a significant challenge. One common question is whether unsold inventory can be depreciated like equipment or buildings. Misunderstanding this can lead to costly mistakes—from missed deductions to IRS red flags.
In this comprehensive guide, we’ll break down everything you need to know about inventory and depreciation. You’ll learn the key differences, relevant laws, examples from real businesses, and how to avoid common pitfalls. By the end, you’ll clearly understand how to handle inventory on your taxes and maximize your deductions legally.
- 📦 Inventory vs Depreciation 101 – Why you cannot depreciate inventory and how those costs are deducted instead (the key IRS rule every business owner should know).
- ⚠️ What to Avoid – Common pitfalls (and IRS red flags) when classifying business assets vs. inventory, so you don’t get caught in a costly tax mistake.
- 💡 Real-Life Examples – Scenarios from retail, manufacturing, and real estate that show how inventory and depreciable assets are treated differently in practice.
- 📚 Laws & Nuances – A plain-English rundown of relevant tax code sections (MACRS, Section 263A, etc.) and even how state inventory taxes or rules might impact you.
- 🤔 Quick FAQs Answered – Concise answers to frequently asked questions about writing off unsold stock, converting inventory to assets, and maximizing deductions legally.
Why Inventory Is Not Depreciable (Straight Answer)
Inventory cannot be depreciated. Depreciation is a tax deduction for property used in your business over time (think machinery, computers, vehicles, or buildings). By contrast, inventory is property you hold for sale to customers in the ordinary course of business. In the IRS’s eyes, inventory is a short-term asset, not a long-term resource that wears out from use. That’s why you cannot claim depreciation on inventory value over time.
Instead of depreciation, inventory gets expensed through a different mechanism: cost of goods sold (COGS). When you sell products, the original cost of those goods is deducted from revenue as COGS. Until inventory is sold (or otherwise disposed of), its cost remains on your balance sheet as an asset, not a deductible expense. This is a fundamental rule in both accounting and tax—no matter how long items sit on the shelf, you generally can’t take a depreciation deduction just for holding them in stock.
For instance, say you started the year with no inventory, bought $100,000 of products, and ended the year with $20,000 still on the shelf. Your COGS for the year would be $80,000 (the cost of the goods you actually sold). The remaining $20,000 stays on your balance sheet as inventory asset going into next year. That $20,000 won’t become a deduction until you sell those products (or otherwise dispose of them). This illustrates how unsold inventory simply carries over, rather than generating a deduction via depreciation.
Common Mistakes to Avoid (Inventory vs. Depreciation)
- Trying to depreciate inventory: A big no-no. Never list unsold inventory on your depreciation schedule. The IRS will disallow it because inventory isn’t a business asset used over time.
- Deducting inventory purchases immediately: Don’t assume you can expense all inventory when bought (unless you meet special small-business exceptions). Normally, you must wait to deduct inventory cost when you sell it. Trying to write off unsold stock upfront is like taking a deduction for items still on your shelf that you could sell later – the IRS won’t allow that double dip.
- Ignoring obsolete or damaged stock: Avoid leaving worthless inventory on your books. Failing to write-down unsellable items means you’ll overstate assets and miss out on a deduction (via COGS) for the loss.
- Not reclassifying items used in the business: If you take an item out of inventory for your own use (e.g. using a product as office equipment), don’t leave it as inventory. Reclassify it as a business asset so you can depreciate it going forward (and remove its cost from inventory).
- Misclassifying business property: Be clear on what’s inventory vs. a capital asset. For example, a real estate developer’s unsold homes are inventory (not depreciable), whereas a landlord’s rental property is a depreciable asset. Getting the category wrong can cause tax headaches.
Detailed Examples: Inventory vs. Depreciation in Practice
Retail Example: Goods for Sale vs. Store Assets
Imagine a small retail shop that sells electronics. The shop owner buys a batch of smartphones wholesale for $50,000 to resell. These smartphones are inventory – they are held for sale to customers. The owner cannot depreciate the $50,000 cost of this inventory. Instead, that cost will sit on the balance sheet as inventory asset value until the phones are sold. As each phone is sold, its cost (say $500 per phone, for example) moves from the balance sheet to the income statement as part of COGS, reducing taxable income at that time. Until sale, no depreciation or deduction is taken on those phones just for aging on the shelf.
Now, say the same shop also spends $5,000 on a new display case and cash register system for the store. Those items are depreciable business assets. The display case and register will be used in the business over several years, not sold to customers. The owner can capitalize that $5,000 as equipment and depreciate it (for example, under MACRS, a cash register might be 5-year property). Each year, a portion of that $5,000 is deducted as depreciation expense (or the owner might elect a Section 179 deduction to write it off in the first year). This illustrates the contrast: the inventory (smartphones) yielded no deduction until sold, whereas the store’s equipment generated annual depreciation write-offs immediately because it’s a long-term use asset.
Real Estate Example: Developer vs. Landlord
Consider two businesses dealing with real estate. Company A is a real estate developer who builds houses to sell. Company B is a landlord who buys houses to rent out. Even though both companies own houses, the tax treatment is completely different:
- Developer (Inventory): Company A’s homes are essentially its “products” for sale – in tax terms, they’re inventory (often called “property held primarily for sale to customers”). The developer cannot depreciate the cost of building those houses, because they’re not being used in the business long-term – they’re built to be sold. All the construction costs are accumulated as inventory. When a house is sold, the costs are deducted as COGS against the sale income. If the housing market slows and Company A holds a completed home for a year, it still gets no depreciation deduction on that unsold home during that time. The profit (or loss) from selling these houses is treated as ordinary income (or loss) from inventory sales.
- Landlord (Depreciable Asset): Company B’s rental home is a depreciable asset because it’s used in the business (providing rental income) over a long term. The landlord will capitalize the $300,000 purchase price of the house and depreciate it – for residential rental property, that’s usually over 27.5 years using straight-line depreciation. Each year, about $10,909 (approximately $300k/27.5) can be taken as a depreciation expense, reducing Company B’s taxable rental income. If the landlord holds the property for years and then sells it, the sale may qualify for capital gains treatment (with some portion taxed as depreciation recapture at higher rates). In short, the rental property yields annual tax deductions via depreciation, while the developer’s sale property (inventory) does not.
Conversion Example: When Inventory Becomes a Depreciable Asset
Sometimes, a business might decide to use an item that was initially meant for sale. When inventory is converted to business use, it becomes a depreciable asset going forward. For example, a car dealership might pull a vehicle off the sales lot to use as a company car or a service shuttle. The moment they do, that car is no longer inventory – it’s now a business asset placed in service.
From a tax perspective, the dealership would remove the car’s cost from the inventory account (it’s as if the business “bought” the car from its inventory at cost). That cost becomes the asset’s basis for depreciation. The dealership can then start depreciating the vehicle like any other company car under the normal depreciation schedule (cars are 5-year property under MACRS). The first year, they can deduct depreciation for that car (or even use a Section 179 deduction if it qualifies), reducing their taxable income.
However, because the car was converted to company use, it cannot also be counted in cost of goods sold – you can’t get two deductions. Essentially, you’re choosing to treat it as a business asset. If the company later sells this used vehicle, it’s selling a depreciated business asset, not inventory. Any gain on that sale could trigger depreciation recapture (taxed as ordinary income) on the amount of depreciation taken. This contrasts with selling inventory, which would have been ordinary income without any prior depreciation deductions. The key point: once inventory is put to business use, it should be reclassified so you can properly depreciate it and follow the correct tax treatment from that point on.
Tax Law Background: Why Inventory Isn’t Depreciable
Understanding the tax code reinforces why inventory is handled differently from depreciable property. The IRS allows depreciation deductions only for assets that meet specific criteria: the property must be used in a trade or business (or held for income production), have a determinable useful life beyond one year, and wear out or decline in value from use. This comes from IRC Section 167 and the Modified Accelerated Cost Recovery System (MACRS) under Section 168. Inventory doesn’t meet these criteria – it’s not used by the business to generate income (instead, it is income, once sold), and it’s generally intended to be sold within a year or so. As Treasury regulations (Treas. Reg. § 1.167(a)-2) plainly state, you can’t depreciate property held primarily for sale to customers (i.e. inventory).
To further clarify, the tax code draws a line between inventory and capital assets or business assets. Internal Revenue Code Section 1221 defines “capital assets” and explicitly excludes two big categories: (1) stock in trade (inventory) and (2) depreciable property used in a business. In other words, inventory and depreciable business assets are separate beasts under the law. Inventory is tied to ordinary income from sales, while depreciable assets get preferential treatment (like capital gains rates on sale, and interim depreciation deductions) under sections like 1231 and 1245/1250. This distinction has been upheld by courts for decades. For example, in Malat v. Riddell (U.S. Supreme Court, 1966), the Court explained that “property held primarily for sale to customers” (inventory) is meant to capture the ordinary business sales, as opposed to assets held for investment or use which might yield capital gain. The takeaway: if something is inventory, tax law denies it depreciation and subjects its profit to regular income tax rates.
Inventory also has its own set of tax rules, separate from depreciation. Businesses must follow inventory accounting under Section 471 (or Section 263A for producers/resellers who must capitalize certain indirect costs into inventory). Essentially, you capitalize the cost of inventory when purchased or made, and you deduct those costs only when the inventory is sold (or worthless). There’s even a special rule from the 2017 Tax Cuts and Jobs Act: small businesses with under $25 million in gross receipts can opt to treat inventory as non-incidental materials and supplies. This lets them expense inventory when it’s used or sold without formal inventory tracking. However, even this provision doesn’t allow “depreciating” inventory – it simply changes when inventory costs are deducted (at sale or use, which is still effectively the same result). Unsold items with future value still can’t be written off for tax purposes until something happens to them (sale, scrap, etc.).
(On tax forms, inventory is handled in the Cost of Goods Sold section, while depreciation is reported separately on forms like Form 4562. This separation on the tax return reinforces that inventory costs and depreciation are distinct deductions.)
Inventory vs. Depreciable Property: Key Differences at a Glance
| Scenario | Tax Treatment & Outcome |
|---|---|
| Retail business: Goods for sale vs. store asset | Goods for sale (inventory): Not depreciable. Cost stays on books until sold, then deducted as COGS. Store asset: Depreciable. Cost is capitalized and written off over time (e.g., 5-year MACRS or via Section 179). |
| Real estate: Property for sale vs. rental property | Property for sale (developer inventory): Not depreciable. Treated as inventory; construction costs capitalized, deducted only when sold (ordinary income). Rental property (landlord): Depreciable. Treated as business asset; depreciated (27.5-year for residential). Annual depreciation deductions; sale qualifies for capital gain (with depreciation recapture). |
| Converting inventory to asset: Using stock in the business | Conversion to asset: Once inventory is put to business use, it’s removed from inventory (no immediate deduction) and becomes a depreciable asset. Basis = original cost. Depreciation starts from conversion date under normal rules. |
Even in specialized industries, the same logic applies. For example, on a farm, livestock held for sale (e.g. cattle raised for beef) is considered inventory and cannot be depreciated, whereas breeding animals or dairy cows used in the farm’s operations are depreciable assets (they’re used to produce income over multiple years). The deciding factor is the purpose: if the asset is primarily for sale, it’s inventory (no depreciation); if it’s for long-term use in the business, it’s usually eligible for depreciation.
| Classification | Pros and Cons |
|---|---|
| Inventory (for sale) | Pros: Entire cost is deductible as Cost of Goods Sold once the item is sold (and if it becomes worthless, it can be written off then). Cons: No depreciation deduction while holding; profit on sale taxed as ordinary income (no capital gains rates). |
| Depreciable Asset (in use) | Pros: Generates depreciation deductions each year (or immediate Section 179 write-off), helping reduce taxable income; may qualify for capital gain rates on sale of the asset (above any depreciation recapture). Cons: Depreciation recapture: any depreciation taken is recaptured and taxed at higher ordinary rates upon sale; plus, you only get depreciation if the asset is being used in business (idle assets not placed in service yield no current deduction). |
Key Terms and Concepts Explained
Internal Revenue Service (IRS)
The IRS is the U.S. government agency responsible for enforcing tax laws and collecting taxes. When we refer to IRS rules or regulations, we mean the official tax guidelines that businesses and individuals must follow. The IRS issues publications (like Pub. 946 on depreciation) and regulations that clarify how tax laws (written in the Internal Revenue Code) are applied in practice.
MACRS (Modified Accelerated Cost Recovery System)
MACRS is the depreciation system used in U.S. tax law for most depreciable assets. It assigns standard depreciation schedules (recovery periods and methods) to different types of property. For example, under MACRS, office furniture is typically 7-year property (meaning its cost is recovered over 7 years), computers and vehicles are 5-year property, and commercial buildings are 39-year property. MACRS often uses accelerated methods (like double declining balance) in early years to give larger write-offs upfront. This system replaced older methods and simplifies depreciation by providing tables for how much depreciation to take each year.
Section 263A (Uniform Capitalization Rules)
IRC Section 263A contains the uniform capitalization (UNICAP) rules. These rules require certain businesses (generally producers or large resellers of inventory) to capitalize (include in inventory costs) not just the direct costs of manufacturing or purchasing inventory, but also a portion of indirect costs (like certain overhead, storage, or administrative expenses). In plain terms, 263A can make your inventory costs higher (by including things like factory overhead), thus delaying those deductions until the inventory is sold. The idea is to match all related costs with the revenue of the product when it sells. Small businesses under the $25 million gross receipts threshold are exempt from 263A post-2018 (a relief that simplifies inventory accounting for them).
Inventory Valuation Methods (FIFO, LIFO, etc.)
These are accounting methods to calculate the cost of inventory sold and remaining at year-end. FIFO (First-In, First-Out) assumes the first items purchased are the first sold, so ending inventory consists of the most recent purchases. LIFO (Last-In, First-Out) assumes the opposite – the latest items bought are sold first, leaving older costs in ending inventory. There’s also average cost method (using weighted average cost per unit) and specific identification (tracking individual item costs). For tax, businesses choose a method and apply it consistently. Additionally, some businesses elect lower of cost or market (LCM) for inventory valuation, meaning if inventory market value drops below its original cost, they can write it down and recognize a loss in value. This isn’t depreciation but an inventory valuation technique that can accelerate the deduction of an inventory loss (because the lost value effectively becomes part of COGS). Using LCM or other special methods often requires consistency and sometimes IRS approval if changing methods, but it’s one way tax law accommodates inventory value drops.
Depreciation Schedules and Classes
A depreciation schedule is the timeline and pattern of depreciation deductions for an asset. Tax law classifies depreciable assets into various classes with set recovery periods. For instance, as mentioned, computers and vehicles are 5-year class, office furniture is 7-year, residential rental buildings are 27.5-year, and so on. The schedule can be straight-line (equal deductions each year) or accelerated (larger deductions in earlier years, as under MACRS for personal property). Businesses often keep a depreciation schedule listing each asset, its cost, its class life, and annual depreciation. This is separate from inventory tracking – since inventory has no depreciation schedule, it doesn’t appear on the depreciation log. Additionally, special depreciation provisions like Section 179 (which allows immediate expensing of certain asset purchases up to a limit) and bonus depreciation (an extra first-year deduction) apply only to qualifying depreciable assets, never to inventory.
Courts and Tax Rulings
Tax disputes sometimes end up in court, such as the U.S. Tax Court, District Courts, or even the Supreme Court. Tax Court rulings and other court decisions set precedents on how laws are interpreted. We mentioned Malat v. Riddell (1966) – a Supreme Court case that helped clarify what “primarily for sale to customers” means (essentially drawing the line between inventory vs. investment property). Courts have consistently upheld that inventory is not depreciable. In cases where taxpayers tried creative arguments (for instance, arguing that something was an investment rather than inventory to get capital gains treatment or depreciation), the courts examine the facts (e.g., the taxpayer’s intent, use of the property, frequency of sales) to classify the property properly. The key entity to remember here is the Tax Court, which is a federal court specializing in tax cases – it often handles disputes about things like inventory accounting, depreciation, and asset classification. Its decisions (as well as those of higher courts on appeal) become the legal backdrop for how the IRS and taxpayers apply the rules.
State-Level Nuances
Federal tax law is uniform across all states, but when it comes to state and local taxes, inventory can be treated differently in some cases. Here are a few things to keep in mind:
- State income taxes: Most states start with federal taxable income, so they generally follow the federal treatment (inventory is not depreciable, and you deduct it via COGS). However, some states may not allow certain federal perks like bonus depreciation or may have their own add-back rules, but those affect depreciable assets – not inventory (which isn’t depreciated at all to begin with).
- Inventory property tax: A big state-level issue is property tax on business inventory. While many states have eliminated inventory taxes, a handful still impose them (either at the state or local county level). For example, states like Texas, Louisiana, Oklahoma, Arkansas, Mississippi, Virginia, and a few others levy an annual tax on the value of inventory held by businesses. This is separate from income tax and essentially treats inventory as taxable property each year. Businesses in those jurisdictions face an extra cost for holding inventory (which is one reason to manage inventory levels efficiently). Some states offer credits or exemptions to mitigate this, but it’s a factor to research based on your state.
- Example – Texas: Texas businesses pay local property tax on inventory values each year. However, Texas offers a “Freeport” exemption for goods that leave the state quickly (usually within 175 days), which can spare wholesalers or manufacturers from tax on inventory destined for out-of-state customers.
- State incentives or nuances: A few states might offer incentives related to inventory (like deductions for inventory donations beyond federal rules, or exemption of inventory from sales tax in certain contexts), but no state lets you “depreciate” inventory on a state income tax return either. They might, however, decouple from certain federal rules – for example, if a state doesn’t conform to the small-business inventory expensing rule (mentioned earlier), you’d have to maintain inventory accounting for state purposes even if you expense it federally. Always check your state’s tax guidelines or consult a CPA for any state-specific inventory rules.
The bottom line is that depreciation generally isn’t an area where state tax law diverges on the definition of inventory – everyone agrees inventory isn’t depreciable. But states can impose additional taxes or compliance requirements on inventory beyond the federal income tax treatment.
Conclusion
In summary, inventory is not depreciable property – and treating it as such is a mistake that can lead to incorrect financials or tax issues. Instead, inventory gets its tax break when it’s sold (or otherwise removed from stock) through the cost of goods sold. Depreciation is reserved for your long-term business assets, like equipment, buildings, and vehicles that help you run the business.
By understanding this distinction, you can ensure your books and tax returns are accurate. Classifying items correctly (inventory vs. depreciable asset) means you’ll take the right deductions at the right time. This avoids IRS red flags and maximizes your legitimate tax benefits. Whether you’re a small retailer, a manufacturer, or a real estate entrepreneur, the core principle stands: if it’s held primarily for sale, it’s inventory (no depreciation); if it’s used in the business for the long haul, it’s a depreciable asset. Keeping that clear line will help you stay on the good side of tax law while making the most of your deductions.
FAQ: Common Questions
- Can I depreciate unsold inventory? No. Unsold inventory isn’t a depreciable asset. You only get to deduct its cost when you sell it (via COGS), or if it’s disposed of with no value.
- How do I write off inventory that won’t sell? You generally write it down to its current value (even zero). This reduction becomes part of COGS or an ordinary loss. Essentially, you’re expensing the unsellable stock through COGS, not via depreciation.
- Can I expense inventory immediately instead of tracking it? Typically no. For tax purposes, inventory isn’t expensed until sold. (Small businesses under certain thresholds can simplify inventory accounting, but unsold inventory with future value still can’t be immediately deducted.)
- What if I use inventory items in my business operations? Remove them from inventory at cost (no COGS deduction) and treat them as business assets. Then you can depreciate them going forward as you would any other asset used in the business.
- Does unsold inventory at year-end reduce my taxable income? No. Unsold inventory is not a deduction. It remains on your balance sheet as an asset. It doesn’t reduce your taxable income until you sell it or otherwise dispose of it.