Starting My Business, Managing My Business, Growing My Business
Business Tax Deduction Strategy – Depreciation
Date:22 October, 2018
Business assets like buildings, equipment, office furniture, copiers, and computers age, wear out and lose their value. Because their useful life is finite, the IRS allows you to, over time, recover the cost (or the basis) of qualified assets.
What qualifies? Most tangible assets, items that are considered a business resource, can be depreciated. Items, like inventory, that can be sold are not considered assets. However, the warehouse where inventory is stored is considered an asset. In general terms, assets are items that can be converted fairly readily into cash if sold. (The words "fairly readily" apply to assets like equipment, because some specialized, expensive machinery may take considerable time to sell.)
It is important to note that because land does not age or wear out, it is not considered an asset that can be depreciated.
Depreciation In Action
Say your company manufactures a variety of automobile parts. You purchase a new piece of equipment. Since the equipment is an asset used in normal operation of your business, it can be depreciated. The IRS assumes the equipment will lose some amount of value each year, therefore, you are allowed to deduct that value through depreciation. Once the asset is fully depreciated, it can remain in service, but you will not be allowed to claim further depreciation as an expense.
Because depreciation is considered an expense, it is listed under Expenses on your Income Statement. Depreciation amounts are calculated using two key numbers: The initial cost of the asset, and the useful life of the asset. Here is a breakdown of some of the useful lives of different categories of assets:
Three Year: Manufacturing tools, farm equipment, and other "light" assets
Five Year: Office equipment, computers, vehicles, light construction equipment
Seven Year: Office furniture, appliances
Thirty Nine Year: Non-residential buildings and facilities
A full breakdown may be obtained from the IRS website or from your accountant.
Three Main Methods Of Depreciation:
Straight-line depreciation is the simplest method used to depreciate assets. Divide the initial cost of the asset by its useful life to determine the annual depreciation amount. For example, if you buy a piece of equipment for $10,000, and its useful life is considered to be three years, you can deduct $3,333.33 per year. The $3,333 is then reported as an expense on the Income Statement.
Under accelerated depreciation, larger deductions may be taken in the first years, with smaller deductions allowed in subsequent years. This method of depreciation is very popular for small businesses. The most commonly used form of accelerated depreciation is called the Modified Accelerated Cost Recovery System (MACRS). MACRS allows a business to take significantly higher depreciation amounts for the first three to four years (depending on the useful life of the asset) and then a reduced amount over the remaining years. Keep in mind the total amount depreciated is the same under straight-line or accelerated depreciation; the only real difference is the timing of the expense allowed. While many businesses use accelerated depreciation in order to get an expense "bump" in the first few years, a business with solid growth potential may prefer straight-line depreciation under the assumption that as revenues grow higher expense allowances in later years can help offset income and provide a better long-term tax benefit. Keep in mind, however, that once straight-line depreciation is chosen, a company cannot switch to MACRS depreciation in subsequent years. But, different depreciation methods can be used for assets acquired in following years.
Section 179 Expense Deduction:
This form of accelerated depreciation allows a business to deduct the entire cost of an asset in the first year it was acquired and used for normal operations. To qualify:
- The asset must be a tangible asset, but not real estate
- The asset must be used primarily for business; rental assets are typically not eligible
- The deduction amount cannot be larger than the company's earned income for the reporting year
- Maximum limits apply;
Two brief caveats:
Intangible assets that have a fixed life - like a patent that will expire after a period of time or a contractual agreement to use a copyright or trademark for a fixed period of time - must be depreciated using the straight-line method.
When you sell an asset before the end of its useful life, any depreciation claimed is subtracted from the cost basis of the asset, which could cause you to show a capital gain on the sale. For example, if you purchase an asset for $10,000, over the course of a few years take depreciation deductions of $5,000, and sell the asset for $7,000, you experience a capital gain of $2,000 even though you originally paid $10,000 for the asset.
Consult your tax advisor for how depreciation might benefit you, depending on your particular tax situation.