As a small business owner, maximizing tax savings is key, and depreciation is a powerful tax break that is often overlooked. Small business depreciation lets you recover the cost of qualifying business assets over time, reducing your taxable income and lowering your tax bill. Recent legislation, including the One Big Beautiful Bill (OBBB), has expended and made several tax breaks permanent, including making bonus depreciation permanent in the tax code. Continuing reading to learn how depreciation gives small businesses more opportunities to save.
What is depreciation and why does it matter for small businesses?
Many of the items you purchase for your business are durable enough to last beyond just one year in service, but they do lose value over time – whether it’s due to wear and tear or other reasons.
Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. It represents how much of an asset’s value has been “used up” and allows businesses to recover that cost gradually through annual tax deductions. By calculating the decrease in your business assets’ value, depreciation can reduce the amount of taxes your business will pay.
Assets depreciate for two main reasons:
- Physical wear and tear, like a delivery van accumulating mileage.
- Obsolescence, such as software being replaced by newer versions.
For small businesses, depreciation is a valuable tool to reduce taxable income. Under Section 179 of the tax code, eligible businesses can choose to deduct the full cost of qualifying property in the year it’s placed in service, rather than depreciating it over time. You must file Form 4562 with your tax return to claim depreciation.
What is the tax impact of small business depreciation?
As a business owner, depreciation is a valuable deduction that can decrease your tax burden. When you purchase long-term assets, like equipment, vehicles, or machinery, you typically can’t deduct the full cost in the year of purchase. Instead, depreciation allows you to spread that cost over the asset’s useful life, reducing your taxable income each year.
By claiming depreciation as a business expense, you lower the amount of income subject to tax. A larger depreciation expense means a smaller tax bill. Depreciation is considered on your business taxes after all revenue forms, operating expenses, cost of goods, and earnings before interest and taxes.
On your financial statements, depreciation appears as an expense that gradually reduces the value of your fixed assets. Over time, this is tracked as accumulated depreciation, which is subtracted from the original cost of the asset. The IRS explains how to depreciate property in Publication 946.
What assets depreciate?
Business assets that depreciate include:
- Office equipment – computers, printers, copiers
- Software – “off-the-shelf” programs used for business
- Vehicles – business-use cars, trucks, vans
- Machinery and tools – used in manufacturing or production
- Furniture – desks, chairs, shelving
- Buildings – commercial property used for business
- Building improvements – HVAC systems, roofing, security upgrades
- Intangible assets – patents, copyrights, trademarks (depreciated as amortization)
Note: Land, inventory, and leased property cannot be depreciated for tax purposes. However, improvements made to land or buildings may qualify for depreciation
You also can’t claim depreciation on any property you also use for personal reasons. It must be used solely for business purposes. For example, if you use a computer for both work and personal use, you can only depreciate the business-use portion.
According to the IRS, if you are trying to claim a depreciation amount on a property, it must meet the following requirements:
- You must own the asset
- You must use the property for your business or produce income
- The asset must have a useful life determined by the IRS
- The asset must last longer than one year
- It must not be specific intangible property, certain term interests, equipment used to build capital improvements, or property placed in service and disposed of in the same year
How to calculate business depreciation
You can calculate depreciation in several ways. Generally, you take the original cost of the asset and subtract the salvage value. Then, divide that number by the years you expect the asset to be useful.
original asset cost − salvage value/ useful life (in years)
= annual depreciation expense
The IRS determines useful life based on a schedule set up for various assets.
You can include a specific amount on your business tax return as an expense during each year of the asset’s useful life.
There are different methods you can use to calculate depreciation. Three of the most common include:
- Straight line depreciation – Spreads the asset’s cost evenly over its useful life.
- Declining balance depreciation – Applies a higher expense in the early years and decreases over time.
- Sum-of-the-years’ digits (SYD) – Uses a weighted approach to allocate more depreciation in the earlier years of the asset’s life.
Other methods include:
- Double declining balance – An accelerated version of declining balance.
- Units of production – Bases depreciation on usage or output rather than time.
Each method calculates depreciation expenses differently. Keep reading to determine which calculation method best fits your circumstances.
Straight line basis
A straight-line basis depreciates a fixed asset over its expected life. To use this method, you must know the asset’s cost that is being depreciated, its expected useful life, its salvage value, and the price an asset is likely to sell for at the end of its useful life.
For example, if your business buys a work computer for $2,000. You expect to use it for 5 years and estimate its salvage value (what it could sell for at the end of its life) to be $500.
Using the straight-line method:
$2,000 (original asset cost) − $500 (salvage value) / 5 years (useful life)
= $300 (annual depreciation expense)
This means you would deduct $300 as a depreciation expense for 5 years.
Declining balance
The declining balance method applies a higher depreciation rate in the earlier years of an asset’s useful life and gradually less in the later years. This method is useful for assets that lose value quickly, such as technology or vehicles. To use this method, you’ll need the asset’s cost, its expected useful life, its salvage value, and the rate of depreciation. The IRS determines depreciation rates based on the type of property, using asset classifications and expected useful life guidelines.
To find the depreciation value for the asset’s first year, use the following formula:
(net book value – salvage value) x (depreciation rate)
For example, let’s say your business buys a machine for $10,000, with a salvage value of $1,000, and a useful life of 5 years, and your depreciation rate is 40%.
Year 1:
($10,000 – $1,000) x 0.40
= $3,600
The remaining value at the end of year one would be $6,400 ($10,000 – $3,600).
Year 2:
(6,400−1,000)×0.40
= $2,160
Book value at end of year two is $4,240 ($6,400 – $2,160). This continues until the book value approaches the salvage value.
Sum-of-the-years’ digits
The sum-of-the-years’ digits method is an accelerated depreciation method where a percentage is found using the sum of the years of an asset’s useful life.
What is bonus depreciation?
Bonus depreciation is a tax incentive that allows businesses to immediately deduct a large percentage of the cost of eligible assets in the year they are placed in service, rather than spreading the deduction over several years.
Under the PATH Act, expanded by The Tax Cuts and Jobs Act, businesses could take 100% bonus depreciation on qualified new and used property acquired and placed in service after September 27, 2017, and before January 1, 2023. This meant the full cost of the asset could be deducted upfront. However, bonus depreciation is now phasing out through 2027.
- 2023: 80%
- 2024: 60%
- 2025: 40%
- 2026: 20%
- 2027: 0%
The increase in Section 179 deductions to $1 million was made permanent by the One Big Beautiful Bill.
As bonus depreciation continues to phase out through 2027, it’s helpful to understand how it compares to other types of depreciation.
- Bonus depreciation: Automatically allows businesses to deduct a large portion of asset costs upfront. Currently phasing out through 2027.
- Section 179 deduction: Offers immediate deductions with annual limits and phase-outs.
- Straight line depreciation: Spreads the asset’s cost evenly over its useful life, offering predictable annual deductions.
- Declining balance: Accelerated method that applies a constant depreciation rate to the asset’s remaining book value each year, resulting in larger deductions early on.
- Sum-of-the-years-digits (SYD): Another accelerated method that calculates depreciation based on a fraction of the asset’s cost, weighted more heavily in the early years.
How to qualify for depreciation deductions
To claim depreciation on your business tax return, the IRS requires that the asset meets specific criteria. These rules ensure that only eligible property used for business or income-producing purposes can be depreciated over time. To qualify for depreciation deductions, the asset must:
- Be owned by your business: You must have legal ownership of the property.
- Be used for business or income-producing activities: Personal-use property does not qualify.
- Have a determinable useful life: The asset must wear out, become obsolete, or lose value over time.
- Be expected to last more than one year: Short-term assets or supplies are not depreciated.
- Be included by IRS rules: Certain intangible assets, term interests, and property disposed of in the same year it was placed in service are not eligible.
