When your business buys an asset (a physical property owned by your company), you can deduct the cost of that asset as a business expense. But, tax regulations say you must spread the cost of that asset over its estimated useful life. That type of long-term deduction is called depreciation.
Depreciation is defined as the value of a business asset over its useful life. The way in which depreciation is calculated determines how much of a depreciation deduction you can take in any one year, so it is important to understand the methods of calculating depreciation.
The general rule for depreciation is that a business should select the depreciation method that is closest to the way the asset's value is estimated to be used up over time.
How Depreciation Follows Asset Value
Here's what happens to an asset over time: Let's say you purchased a piece of computer equipment for your business at a cost of $1,000. The average computer lasts 10 years, so it decreases in value by 10% each year.
For example, if you buy a vehicle for $25,000, you calculate depreciation on the $25,000, whether you paid for it with cash or credit. If you lease the vehicle, you can still depreciate it, depending on the type of lease.
Depreciation is just an accounting mechanism to show the expense of using an asset over time. It doesn't have anything to do with how you purchased the item, its real physical condition, or its actual life.
Business Assets That Are Depreciated
Business assets are items of value owned by your business. Most higher-cost business assets are depreciated, because they decrease in value over time, either through use or because they become obsolete. When an asset becomes obsolete, it may be because it has been replaced by something newer or because it is deteriorating.
The types of assets that are depreciated are called property, plant, and equipment (PPE). These items include buildings, improvements to your property, vehicles, and all kinds of equipment and furniture.
You can depreciate business property you own that is used by your business or income-producing activity. It must have a useful life that can be determined and it must be expected to last for more than a year.
You can't depreciate:
- Property that's expected to be used up within a year (like office supplies),
- Equipment used to build capital improvement, or
- Certain intangible assets, like computer software and term interests.
Intangible assets may be amortized, using a process similar to depreciation. You also can't depreciate land because it does not decrease in value.
How to Calculate Depreciation
Depreciation is calculated by taking the useful life of the asset (available in tables, based on the type of asset, though you may need an accountant for this), less the salvage value of the asset at the end of its useful life (also determined by a table), divided by the cost of the asset (including all costs for acquiring the asset like transportation, set-up, and training).
The Depreciation Calculation
Depreciation is calculated each year for tax purposes. The first-year depreciation calculation is:
Cost of the asset - salvage value divided by years of useful life = adjusted cost.
Each year, use the prior year's adjusted cost for that year's calculation.
The next year's calculation is based on the previous year's total.
Book Value of Business Assets
The book value of an asset is how it's shown on the business balance sheet. Each year the book value changes because some of the value has already been depreciated. Take an asset that has a value of $50,000. The useful life is 20 years and the salvage value is $1,000, so the depreciation for each year is $2,450 (50,000 - 1,000 divided by 20).
|Book Value of an Asset - First Three Years|
|Year||Asset book value at beginning of year||Depreciation expense for the year||Asset book value at end of year|
|1 (full year)||$50,000||$2,450||$47,550|
For accounting and tax purposes, the asset must be placed in service (set up and used) in the first year that depreciation is calculated.
When the Asset Reaches Its Useful life
When an asset has been fully depreciated, it is considered to be "off the books" of the company. That doesn't mean the asset isn't still useful, but that the company cannot take any more depreciation expense on that item. Some items may have a salvage value or residual value, a value at the end of the depreciation period. That salvage value stays on the books until the item is sold or scrapped.
There are several methods used to calculate depreciation. For each method, you'll need to know:
- Adjusted basis (total cost)
- Salvage value, if any
- Useful life.
Straight Line Depreciation. The method described above is called straight-line depreciation, in which the amount of the deduction for depreciation is the same for each year of the life of the asset.
Double Declining Balance. This method includes an "accelerator," so the asset depreciates more at the beginning of its useful life (used with cars, for example, as a new car depreciates faster than an older one). With this method, depreciation expense decreases every year of the asset's useful life.
Usage-Based Depreciation. Some assets contribute more to revenues in varying amounts from year to year. The depreciation expense for these assets might be higher or lower in some years. In these cases, the depreciation expense for each year is based on the units of production or units of output generated by the asset. An example of this would be a machine that made car parts.
Favorable tax plans are available to speed up the depreciation process so you can get more tax deductions faster. These plans come in two forms:
- A tax deduction, called a Section 179 deduction, for the purchase of business vehicles and equipment, and
- Bonus depreciation for the purchase of "new to you" property.
Find the Useful Life of an Asset
The IRS has classifications of assets and has calculated useful life on these classes. You can find a listing of the asset classes in IRS publication 946, or your CPA can help you to find these values and to calculate depreciation on individual business assets.
Amortization vs. Depreciation
In accounting, the amortization process differs from the depreciation process mainly in that amortization is used for intangible assets, like intellectual property (copyrights, trademarks, and patents). You can also amortize business startup costs, goodwill, research costs, costs forgetting a lease, and other similar costs.
Amortization calculations work similar to straight-line depreciation, with an annual deduction to recover the cost of the property over a specific time period.
Depreciation Calculations on Your Business Tax Return
To include depreciation or amortization costs on your tax return, use IRS Form 4562 Depreciation and Amortization. You also must use this form to claim a section 179 deduction or special bonus depreciation.
Depreciation calculations are complicated and there are many tax restrictions and qualifications that you must meet. Keep good records on your business assets and get help from your tax professional to include depreciation costs in your business tax return.