Most business expenses are deductible because they are an ordinary and necessary business expense. You spend money for an item in the current year and you get a deduction for that expense in that year. For example, you buy office supplies for $200 and you get an ordinary and necessary business tax deduction for those $200 of supplies because you spent money on it in the current year.
Depreciation is something that you can get a deduction for in the current year even though you might not have spent money to buy it in that year. For instance, you bought a computer system in 2017 for $5,000. The life of a computer is 5 years, so you will get a write-off the $5,000 over the next five years (taking the expense to reduce your business taxes).
Even though in 2019 you did not spend any cash for the computer (since you bought it for cash) you will get a deduction for that computer you bought in 2017 since it is being written off over 5 years starting in 2017 when you purchased it. Therefore, in 2019, you get a deduction for a non-cash expense.
Depreciating assets give you more income on your profit and loss statement and increase your assets on your balance sheet. The computer you bought in 2017 for $5,000 less the depreciation of $1,000 taken in 2017 leaves a net income of $4,000 and increases your assets on your balance sheet by the same $4,000. Any third party looking at a business’ financial statements likes to see increased net income and an increase in assets over liabilities.
Accelerated Depreciation and How It Applies to Specific Products
When you depreciate, or "write off," an asset over its useful life, you can take more depreciation in the initial years with accelerated depreciation. Depreciation on purchases of business assets can be accelerated, allowing you to deduct more of the purchase price earlier, sometimes entirely in the first year.
Each class of assets has a life and table that specifies the amount of accelerated depreciation you are entitled to each year (your CPA can show you this table). You can also make an election under Section 179 to take all of the depreciation in the year of purchase, and you may also be eligible to take a bonus depreciation deduction for purchasing new assets.
The Benefits of Accelerated Depreciation
The benefit of accelerated depreciation is that you are getting more of a tax deduction in earlier years and therefore you get a return of more of your tax money earlier versus later.
It is important to realize that depreciation is not now or never... it is now or later. And sometimes taking the deduction in later years is better. If you expect to be in a higher income bracket in later years, it would not be in your best interest to accelerate the deduction but instead to write off the asset utilizing the straight-line method (that is, an equal amount of depreciation every year); therefore saving the deduction for the years you are in a higher tax bracket.
You must keep a copy of the invoice that shows exactly what you purchased plus proof of payment. Many states will check business assets you purchase to make sure you paid the applicable sales tax on the asset. Even if you bought the asset in another state, you must pay use tax to your state if sales tax was not charged.
When to Take Depreciation
You take the depreciation expense at the end of the year, so it can be included in your taxes. But knowing when to take how much depreciation over the life of the asset, that is the million dollar question. The choices are to take the depreciation all in the year of purchase (under Section 179) or take the depreciation over the life of the asset, with an option of accelerating the depreciation deduction to the earlier years of purchase.
Careful tax planning will tell you which option is most beneficial for you depending on your projected tax bracket each year and anticipation of changes in the tax law. Consult with your tax professional to help you determine depreciation deductions for specific business assets.
The determination of the depreciation method that will work best for you can be time-consuming; however, the benefits of taking the depreciation deduction in the years that most benefit your financial statements and tax returns are worth the effort. Having a first-rate CPA on your team is always important.
The IRS and Depreciation
A final note: Taking tax deductions on the purchase of business assets is more complex than you might think. The IRS imposes limitations and restrictions on the amount and type of depreciation you can take on business assets.