Depreciation and Business Taxes
When you hear the term "depreciation," you probably think of driving your new car off the lot and having it immediately begin to decrease in value or depreciate. While it's not great to have your property lose value, there are some benefits to business owners.
What Is Depreciation?
Businesses are able to take tax deductions on expenses incurred when doing business, but for big purchases, this expense is deducted over time. According to the Internal Revenue Service (IRS):
Depreciation is the recovery of the cost of the property over a number of years. You deduct a part of the cost every year until you fully recover its cost.
Business assets that can be depreciated include equipment, machinery, technology, computers, office furniture, buildings, and improvements to buildings. Land can't be depreciated because it appreciates instead of depreciating, however, you may be able to depreciate buildings and land improvements on the land.
Business assets that you can't claim depreciation on include any property you also use for personal purposes. For example, if you use your car for both business and personal use, you can only depreciate the business-use portion.
IRS Depreciation Rules
The IRS says that property must meet the following requirements to claim depreciation:
- You must own the property.
- The property must be used in a business or an income-producing venture.
- It must have a determinable useful life.
- It needs to last longer than one year.
- It must not be excepted property, such as certain intangible property, certain term interests, equipment used to build capital improvements, and property placed in service and disposed of in the same year.
Depreciation is taken on business assets to recognize the change in the value of these assets as they age. Assets depreciate for two reasons.
That auto you bought and drove off the lot will decrease in value with every mile and the wear and tear on the engine, the tires, and other components. Assets also decrease in value because they become obsolescent, needing to be replaced by newer models. Last year's car model is less valuable because there's a newer, more desirable version on the market.
Updated Depreciation Benefits for Businesses
When the PATH Act was enacted late in 2015 to protect taxpayers from fraud, it increased the ability of businesses to take more depreciation on purchases of business assets in the first year of ownership.
Bonus depreciation on purchases of new, qualified business assets is 100% if acquired and placed into service after September 27, 2017, and before January 1, 2023. Businesses can write-off the full cost of depreciable property such as machinery, equipment, computers, appliances, and furniture.
Section 179 deductions for purchases of all types of assets were raised from $500,000 to $1 million for tax years starting after 2017. This deduction applies to tangible personal property used in a trade or business, and, if the taxpayer chooses, it can be used in real property and some property improvements, such as roofs, heating, and alarm systems.
How Depreciation Is Calculated
Depreciation is calculated in various ways, but the process generally includes the original cost of the asset, including costs of acquiring the asset, transporting it, and setting it up. The asset's salvage or "scrap" value is then subtracted. This number is then divided over the years of "useful life" of the asset. Useful life is determined by the IRS based on a schedule set up for various types of property. The business can include a specific amount on its income tax return as an expense during each year of the useful life of the asset. This reduces the taxable income of the business.
As an example, if a business purchases office furniture for $20,000; the furniture has a useful life of 10 years and a scrap value of $1,000. Using straight-line depreciation, the resulting $19,000 cost is divided over the furniture's 10 years of life. The business can, therefore, deduct $1,900 in depreciation on its tax return in each of those 10 years.
Methods of Depreciation
Depreciation is determined by one of several methods that have been approved by the IRS. The most common method is the straight-line depreciation used in the above example. Other methods are double-declining balance and sum-of-the-years'-digits, both of which allow for more depreciation in the early years of owning the asset. You might benefit from one depreciation method more than another so consult with a tax professional to determine which one is best for you to use.
Depreciation can also be accelerated, allowing a business to deduct more of the cost of the asset in earlier years. The two most common types of accelerated depreciation are Section 179 expenses and bonus depreciation.
Depreciation and Asset Purchase Method
Depreciation of a business asset has nothing to do with the way the asset was purchased. Whether a business vehicle is bought with cash or a loan doesn't affect the depreciation calculation. But leasing an asset can affect the ability of your business to depreciate it. According to the IRS, if your lease agreement ends in a purchase, then you can depreciate the property. However, if the lease is simply a long-term rental, then you can take the rental fee as a business deduction.
Always seek help from a tax professional so you're sure that you're using the right depreciation method for your business.
IRS. "Topic No. 704 Depreciation." Accessed Jan. 28, 2020.
IRS. "PATH Act Tax Related Provisions." Accessed Jan. 27, 2020.
IRS. "During Small Business Week, IRS Spotlights Expanded Tax Benefits for Depreciation and Expensing." Accessed Jan. 27, 2020.
Freshbooks. "How to Calculate Depreciation." Accessed Jan. 28, 2020.
Massachusetts Institute of Technology. "Taxes and Depreciation," Page 2. Accessed Jan. 28, 2020.
IRS. "Small Business Self Employed FAQ." Accessed Jan. 28, 2020.