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. However, 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's important to understand the methods of calculating depreciation.
- Depreciation is a method for spreading out deductions for a long-term business asset over several years.
- The basic way to calculate depreciation is to take the cost of the asset minus any salvage value over its useful life.
- Depreciation is handled differently for accounting and tax purposes, but the basic calculation is the same.
- Taking depreciation expenses each year is a way to reduce your business tax bill.
How Depreciation Works
When your business buys property for long-term use, you can take deductions for the cost of the property by spreading it over several years using a process called depreciation. The Internal Revenue Service (IRS) calls this type of property (like vehicles, machinery, equipment, and furniture) capital assets.
Let's say you purchased a piece of computer equipment for your business at a cost of $8,000. The average computer lasts 10 years, so it decreases in value by 10% each year. You can take a deduction for depreciation of $800 each year on your business tax return.
Depreciation is just an accounting method 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 the number of years it's actually used in your business. For example, if you buy or lease a car for your business, you can depreciate it, depending on the type of lease.
What Assets Can You Depreciate?
The types of business assets you can depreciate are called capital assets (called "property" by the IRS). These items include buildings, improvements to your property, vehicles, and all kinds of equipment and furniture.
You can depreciate assets used by your business for income-producing activity. The asset 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 improvements
- Certain intangible assets, like computer software, patents, or trademarks
You also can't depreciate land because it does not decrease in value.
How To Calculate Depreciation
To calculate depreciation, you need to know:
- The cost of the asset (asset basis), including costs for buying the asset, shipping, setup, and training
- The useful life of the asset (also called the recovery period)
- The salvage value at the end of its useful life
You can find the useful life (called "recovery period" for tax purposes) of specific business assets in Publication 946 How to Depreciate Property.
Depreciation is calculated each year for tax purposes. The most common depreciation is called straight-line depreciation, taking the same amount of depreciation in each year of the asset's useful life.
For example, the first-year calculation for an asset that costs $15,000 with a salvage value of $1,000 and a useful life of 10 years would be $15,000 minus $1,000 divided by 10 years equals $1,400.
The asset must be placed in service (set up and used) in the first year that depreciation is calculated.
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/recovery period
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.
Declining Balance. This method includes an "accelerator," so the asset depreciates more at the beginning of its useful life. It's 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. There are several types of declining balance, including a 200% method and a 150% method.
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 depreciating a machine that makes car parts.
The IRS requires businesses to use the modified accelerated cost recovery (MACRS) system for accelerated depreciation. Most businesses use the general depreciation system (GDS) under MACRS to calculate the declining balance and straight-line depreciation methods.
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. Salvage value stays on the books until the item is sold or scrapped.
Special Additional Depreciation
Favorable depreciation options are available to speed up the depreciation process so you can get more tax deductions faster. There are two types:
- A Section 179 deduction for the buying business vehicles and equipment
- An additional bonus depreciation for the first year you buy and use the asset
These special types of additional deductions come with limits and qualifications, so check with your tax professional to see if you qualify.
Reporting Depreciation on Your Tax Return
To calculate depreciation deductions for your tax return, you'll need to use IRS Form 4562. You also must use this form to claim a section 179 deduction or special bonus depreciation. Before you file the form, you'll need to separate assets
- Those you bought during the tax year and those you bought in previous years
- The property classification by recovery period years
- The depreciation system (MACRS is the most common)
Depreciation for vehicles is shown in Section B of Part V of the form. You then add this amount to your business income tax form, depending on your business type.
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.
Frequently Asked Questions (FAQs)
What is bonus depreciation?
Bonus depreciation is a special type of accelerated depreciation that you can take to write off most of the cost of depreciable business assets in the year they were first placed in service (set up for use). This 100% deduction applies to assets with a recovery period of 20 years or less, including machinery, equipment, and furniture. You can take it in addition to other depreciation.
How do you record depreciation?
You can record depreciation in your small business accounting system using business accounting software. You begin by entering the basic information about each asset: cost, residual value (salvage value), and estimated useful life.
At the end of each year, record the depreciation expense for the year and the increase in accumulated depreciation. The difference between these two amounts is the book value of the asset. Your software program adds up the information about all assets for the "Asset" side of your business balance sheet. Each type of asset is listed separately, offset by total accumulated depreciation, for the net value of all assets.
What is depreciation recapture?
When you sell or get rid of business assets you depreciated using the MACRS system, any gains are generally recaptured as ordinary income up to the amount of the allowable depreciation for the property.
One common example is an asset on which you took a section 179 deduction. In this case, the amount you must include as income on your tax return is the difference between the amount of the deduction you claimed using the section 179 deduction and the amount of allowable deduction without considering this special deduction.