The concepts of depreciation and amortization can be confusing to businesspeople who don't work with them every day, but it's important to know about these terms and how they can work to help minimize the tax bill for your business.
Depreciation and amortization are both methods for recovering costs of business assets (property) over a number of years, with depreciation being used for physical assets and amortization used for intangible (non-physical) assets.
What's the Difference Between Amortization and Depreciation?
The IRS requires businesses to follow specific regulations in order to be able to deduct the costs of business assets (the IRS calls them "property"). The two cost-recovery options are depreciation and amortization.
|Amortization vs. Depreciation|
|Asset type||Intangible (non-physical) property||Tangible physical property|
|Recovery period||Usually 15 years||Varies based on the useful life of the asset|
|Value at end of the recovery period||None||Salvage value|
|Yearly deduction calculation||Works like straight-line depreciation||Straight-line and accelerated options|
|Accelerated options: Section 179 and bonus depreciation||Not available||Available if qualifications are met|
Types of Assets
The concept of both depreciation and amortization is a tax method designed to spread out the cost of a business asset over the life of that asset. Business assets are property owned by a business that is expected to last more than a year.
Amortization is used for non-physical assets called intangibles. Types of intangibles include:
- Technology, like computer software
- Goodwill and customer relationships
- Trade secrets, like a secret formula or process
- Intellectual property (copyrights, trademarks, and patents)
Business startup costs and organizational costs are a special kind of business asset that must be amortized over 15 years. A limited amount of these costs may be deducted in the year the business first begins.
Depreciation is used for physical assets, like:
- A company car
- A building your company owns
- Office furniture
- Retail shelving or racks
- Machinery or equipment
- Warehouse vehicles and equipment
You can't depreciate land or equipment used to build capital improvements. You can't depreciate property used and disposed of within a year, but you may be able to deduct it as a normal business expense.
The recovery period is the number of years over which an asset may be recovered. Intangible assets are usually amortized over 15 years. There is no value at the end of this time.
Tangible assets are recovered over what the IRS calls their "useful life," which is determined based on the asset type. See IRS Publication 946 How to Depreciate Property for more details on asset classification or ask your tax professional.
Amortization and Depreciation Calculations
Amortization for intangibles is valued in only one way, using a process that deducts the same amount for each year. The amortization calculation is original cost (called the basis) is divided by the number of years, with no value at the end.
Depreciation can be calculated in one of several ways, but the most common is straight-line depreciation that deducts the same amount over each year. To calculate depreciation, begin with the basis, subtract the salvage value, and divide the result by the number of years of useful life.
The other depreciation methods result in larger amounts of deductions in earlier years. Here are some examples:
- Declining balance for assets like cars that lose more value in the first years of use
- Units of production based on the total number of hours used or units produced over the asset's useful life
- Sum-of-the-year's digits for higher expenses in early years and lower expenses in later years
Accelerated Depreciation Options
The IRS allows businesses to take several accelerated depreciation deductions for tangible business assets and some improvements. These special options aren't available for the amortization of intangibles.
Section 179 deductions allow you to recover all of the cost of an item in the first year you buy and start using it. This deduction is available for personal property (like machinery and equipment) and qualified real property (land and buildings) and some improvements to business real property. There are limits on the amount of deduction you can take for each item and an overall total limit. You can only use this deduction for property that is used more than 50% for business purposes, and only the business part of its use can be deducted.
In addition to taking a Section 179 deduction, you may able be able to take an additional 100% (bonus) depreciation deduction for the first year an asset is placed in service.
Depreciation and amortization are complicated and there are many qualifications and limitations on being able to take these deductions. Get help from a licensed tax professional for this process.
Frequently Asked Questions (FAQs)
How does depreciation and amortization work for a home business?
Since amortization doesn't deal with physical assets, the process is no different for a home business than any other business that owns intangible property.
A home business can deduct depreciation expenses for the part of the home used regularly and exclusively for business purposes. When you calculate your home business deduction, you can include depreciation if you use the actual expense method of calculating the tax deduction, but not if you use the simplified method.
What is negative amortization?
Another definition of amortization is the process used for paying off loans. The loan amortization process includes fixed payments each pay period with varying interest, depending on the balance. Negative amortization for loans happens when the payments are smaller than the interest cost, so the loan balance increases.
How do I include depreciation and amortization in my business tax return?
Most businesses file IRS Form 4562 Depreciation and Amortization to do the calculations for depreciation and amortization for the year. The information for all property depreciated and amortized is accumulated and totaled on this form. The Section 179 election amount is calculated in Part I and bonus depreciation is calculated in Part II. You must add this form to your other business tax forms or schedules when preparing your business taxes.