How Depreciation Can Affect Your Personal or Business Taxes
Depreciation is an income tax deduction that allows a taxpayer to recover the cost of property or assets he’s purchased and “placed in service," meaning it is used in his trade or business. A fixed asset is an asset that a business or firm will use to earn income. In this situation, the owner of the business does not anticipate selling the asset within a year of acquiring it, but rather the asset will still be "in service" after that period of time and will help produce long-term income. Residential real estate can also be depreciated.
Examples of depreciable assets include:
- Computers and software
- Other standard office equipment
Depreciation is contrasted with an expense. Business expenses, which commonly include cash transactions such as a business luncheon, are fully deductible in the year in which they were incurred. The expense of purchasing a fixed or tangible asset can be depreciated and spread out over a number of years.
Businesses have a choice as to how to take a depreciation deduction. They can either write the cost off as an expense or they can deduct it as depreciation. If the business chooses to write it off as an expense, they can deduct the entire cost in the first year. Or, they can depreciate it and write the asset’s value off over its useful life expectancy. For example, if a business purchases a $70,000 piece of equipment, it can take the entire $70,000 in year one or deduct $10,000 a year for seven years.
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.
Methods of Calculating Depreciation
Methods for calculating depreciation are detailed thoroughly in IRS Publication 946, How to Depreciate Property. They include:
- Straight-line depreciation: This method 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.
- Accelerated depreciation: The bulk of depreciation takes place in earlier years and the deductions in later years are much smaller.
- Section 179 expense deduction: This allows businesses to take a deduction for the entire value of the property or asset in the first year. The deduction is capped at $500,000. If the deduction is greater than the income of the business, then the business can carry the balance of the value over to later tax years.
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.