How Depreciating Assets Can Affect Your Business Taxes
You have three options for depreciating business assets
An asset's depreciation can be an income tax deduction that allows taxpayers to recover the cost of property or assets they've purchased and “placed in service" in the course of their trade or business.
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
Types of depreciable assets include:
- Computers and software
- Other standard office equipment
Qualified real property has been 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 use is to build capital improvements.
Residential real estate can also be depreciated, provided it's a rental property.
Depreciation vs. Business Expenses
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.
Businesses generally have a choice as to how to take a depreciation 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.
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.
How to Take a Depreciation Deduction
Methods for calculating depreciation are detailed thoroughly in IRS Publication 946, How to Depreciate Property.
- 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 2019, but you must deduct from this amount the cost of Section 179 property that exceeds $2,550,000 if it was placed in service in that year. 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.
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.
Sport utility vehicles placed in service in 2019 are limited to a Section 179 deduction of $25,500.
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.