How Depreciating Assets Can Affect Your Business Taxes
You have three options for depreciating business assets
The purchase of a fixed asset can be an income tax deduction that allows taxpayers to recover the cost of property or assets they've “placed in service" in the course of their trade or business. They generally can't deduct the entire cost of an asset in the year of purchase if it's a capital expenditure, but they can break the cost down over a number of years instead in a process known as depreciation.
A fixed asset is one that a business or firm will use to earn income. The owner of the business doesn't anticipate selling the asset within a year of acquiring it. It will continue to be "in service" after that period of time and it will help produce long-term income.
Examples of Depreciable Assets
Various types of assets can be depreciated. They include:
- Computers and software
- Other standard office equipment
Qualified real property became depreciable in tax years 2017 and later. This is property that has been improved according to Section 168 (e)(6) of the Internal Revenue Code. Qualified improvements include but aren't limited to heat and air conditioning and security systems. Check with a tax professional to find out if your property qualifies.
The business must own the property, and it must be used to generate income. Intangible property generally doesn't qualify, nor does equipment that's intended to build capital improvements. The asset must have a useful life that can be determined, and it must be expected to last more than a year.
Residential real estate can also be depreciated, provided it's a rental property.
Depreciation vs. Business Expenses
Deductible business expenses commonly include cash transactions such as business luncheons, which are fully deductible in the year in which they were incurred. The expense of purchasing a fixed or tangible asset can be spread out over a number of years when it's depreciated.
In some cases, businesses might have a choice as to how to take a deduction. They can either deduct the entire cost in the first year when it elects to write it off as an expense, or it can depreciate it and write the asset’s value off over its useful life expectancy. For example, a business can take the entire $70,000 in year one or deduct $10,000 a year for seven years when it purchases a $70,000 piece of equipment unless it's clearly a capital expenditure.
You must generally use the Accelerated Cost Recovery System (ACRS) to depreciate property that you placed in service before 1987. Used the Modified Accelerated Cost Recovery System (MACRS) for tax years 1987 and later. The IRS provides worksheets to help with calculating depreciation using MACRS.
Time Periods for Calculating Depreciation
Various types of property are subject to different periods of time over which they must be depreciated. Depreciation calculates how much of an asset's value will be “used up” over these periods of time. For example:
- Manufacturing tools and tractors depreciate over a period of three years.
- Computers, office equipment, light vehicles, and construction equipment depreciate over a period of five years.
- Office furniture and miscellaneous assets depreciate over a period of seven years.
- Residential real estate depreciates over a period of 27.5 years.
- Commercial real estate depreciates over a period of 39 years.
- Improvements to land depreciate over periods of 10, 15, or 20 years, with some exceptions.
Depreciation of assets in use for less than a full year in their first year can be prorated for the number of months they were in use, according to the IRS.
How to Take a Depreciation Deduction
Methods for calculating depreciation are detailed thoroughly in IRS Publication 946, How to Depreciate Property. They include:
- Straight-line depreciation: This is simple and straightforward, but immediate gratification is limited. Your largest deductions will come in later years. New businesses that are just starting out and expect to be much more profitable in later years often choose this method, deferring the greatest deductions to a later time when they'll presumably have more income to offset.
- Accelerated Depreciation: The bulk of depreciation takes place in earlier years and the deductions in later years are much smaller if you elect accelerated depreciation. This might be a good option if a business is experiencing a banner year and needs as much in the way of deductions in the current year as possible.
- A Section 179 expense deduction allows businesses to take a deduction for the entire value of the property or asset in the first year. The deduction is capped at $1,020,000 as of the 2019 tax year—the return you'll file in 2020. You must deduct from this amount a percentage of the cost of Section 179 property that exceeds $2,550,000 if it was placed in service in that year. This is referred to as the "phase-out threshold." The Tax Cuts and Jobs Act (TCJA) effectively doubled this limit from what it was in 2017, and it provides that it be adjusted periodically for inflation.
Sport utility vehicles placed in service in 2019 are limited to a Section 179 deduction of $25,500.
The business can carry the balance of the value over to later tax years if the deduction is greater than the income of the business.
NOTE: Tax laws change periodically, and you should consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and is not a substitute for tax advice.
IRS. "Topic No. 704 Depreciation." Accessed March 23, 2020.
Business Economics. "The Definition of Fixed Assets." Accessed March 23, 2020.
IRS. "Publication 946 (2018), How To Depreciate Property." Accessed March 23, 2020.
Corporate Finance Institute. "What is Straight Line Depreciation?" Accessed March 23, 2020.
Corporate Finance Institute. "What is Accelerated Depreciation?" Accessed March 23, 2020.
IRS. "New Rules and Limitations for Depreciation and Expensing under the Tax Cuts and Jobs Act." Accessed March 23, 2020.