Depreciation and Business Taxes
Depreciation is better for businesses than for individuals
When you hear the term "depreciation," you probably think of driving your new car off the lot and having it immediately begin to depreciate—decrease in value. As a general rule, depreciation works better for businesses than it does for individuals.
Depreciation is actually a helpful tax-saving measure for businesses. If you're a business owner, it's important to learn how it works so you can take advantage of it.
Updated Depreciation Benefits for Businesses
When the PATH Act was enacted late in 2015, it included some changes to depreciation calculations that benefit small businesses. PATH 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 business assets returned and will remain at 50 percent of the value of assets placed into service. Section 179 deductions for purchases of all types of assets have been permanently set at a maximum of $500,000. These changes allow businesses to plan for asset purchases and Congress hopes this will encourage business capital purchases.
What Is Depreciation?
Depreciation is a "non-cash" expense that reduces the value of an asset over time. When depreciation is non-cash, this means that it is taken as an accounting entry and the amount of cash held by the business is not affected.
Business assets that can be depreciated include equipment, machinery, technology, computers, office furniture, buildings, and improvements to buildings. They include leasehold improvements to rented property and business vehicles. Land can't be depreciated because it appreciates instead of depreciating.
Depreciation is taken on business assets to recognize the change in 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—they are replaced by newer models. Last year's car model is less valuable because there's a newer, more desirable version on the market.
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, let's say that 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 straight-line depreciation used in the above example. Other methods are double-declining balance and sum-of-the-years'-digits. 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. Again, this is something you'd want to speak about with a tax professional so you're sure the option you select is the best for your particular business.