The information in this article is up to date through tax year 2020 (taxes filed in 2021).
As a small business owner, you probably take as many tax breaks as you’re eligible. But did you know that depreciation of your assets can provide you with an overlooked deduction? The term “depreciation” typically has a negative connotation. It means that an item you own gradually decreases in monetary value. But this can be helpful to business owners, specifically regarding their taxes.
What is depreciation?
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 defined as an accounting method of allocating the cost of a tangible or physical asset over its life expectancy. It represents how much of an asset’s value has been used. By calculating the decrease in your business assets’ value, depreciation can reduce the amount of taxes your business will pay.
Assets depreciate for two reasons. Assets decrease in value every time they are used, like a car that gains miles and wear and tear. Assets can also drop in value because they become outdated, like computer software replaced by a newer version.
Depreciation allows small business owners to reduce an asset’s value over time due to its age, wear and tear, or decay. Business owners can claim depreciation as an annual income tax deduction listed as an expense on their income statement. File Form 4562 with your tax return to claim it.
What assets depreciate?
Business assets that depreciate include:
- work computer
- off-the-shelf computer software
- business vehicle
- office furniture
- improvements made to buildings
- intangible properties (patents, copyrights, etc.)
Land, inventory, and leased property can’t depreciate for tax purposes. However, you may be able to depreciate improvements made on the land or buildings built on the land.
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 do I calculate 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. 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:
- straight-line basis
- declining balance
- double declining
- units of production
- sum-of-the-years’ digits
Each method calculates depreciation expenses differently.
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.
The declining balance method applies a higher depreciation rate in the earlier years of an asset’s useful life than the later years. It requires that taxpayers know the asset’s cost, its expected useful life, its salvage value, and the rate of depreciation.
To find the depreciation value for the asset’s first year, use the following formula:
(net book value – salvage value) x (depreciation rate)
To find the depreciation value for the asset’s final year, use the following formula:
(net book value at the start of the last year) – (estimated salvage value)
The sum-of-the-years’ digits is an accelerated depreciation method where a percentage is found using the sum of the years of an asset’s useful life.
What is the tax impact of calculating depreciation?
As a business owner, you can use depreciation to decrease your tax burden.
Your business’s depreciation expenses reduce the number of earnings on which your taxes are based, reducing the amount of taxes you owe. A considerable depreciation expense will lower your taxable income by a significant amount and reduce your business’s tax bill.
Depreciation is considered on your business taxes after all revenue forms, operating expenses, cost of goods, and earnings before interest and taxes. The total amount of depreciation expense is shown as accumulated depreciation on your balance sheet. This is subtracted from the gross amount of fixed assets. Depreciation increases each month as expenses are charged against the business’s assets.
The IRS explains how to depreciate property in Publication 946.
Are there any other depreciation-related benefits to businesses?
The PATH Act allows businesses to take more depreciation on purchases of business assets in the first year they own the item.
Businesses can take bonus depreciation on their purchases of new and qualified business assets. This depreciation will be 100% if the item is acquired and you begin to use it after September 27, 2017, but before January 1, 2023.
The Tax Cuts and Jobs Act raised the Section 179 deductions for all business asset purchases from $500,000 to $1 million for tax years after 2017. Patents and copyrights are depreciable assets as well, but land is not.
Benefits of Section 179 and bonus depreciation
It costs a lot to establish a new business. The initial expense of purchasing equipment, materials, and even new electronics tends to hit new businesses especially hard. Deducting the full cost of these assets right away relieves some of your overall financial burden by significantly reducing your tax bill that first year. Depreciating the cost would mean less relief up front, at a time when you might need it most.
There can be other benefits to deducting the full cost of an item in a single year. Computers, for example, tend to become obsolete in a short period of time. If think you will replace your computer every couple of years, it probably makes financial sense to deduct the full value each time you purchase a new one. Otherwise, if you depreciate the expense but then you retire your computer before you have recovered the full cost, you will lose some of the value.