The Right Way to Calculate Depreciation for Your Small Business
Everything small business owners need to know to feel confident claiming depreciation on the business taxes.
It’s tax time.
And if you’re like every small business owner we work with, you’re looking for all possible (legal, of course) ways to save money on your business taxes. You want to take every single business deduction you’re entitled to.
One deduction many small business owners forget, aren’t aware of, or think is too complicated for them is depreciation (sometimes referred to as amortization).In short, it allows you to leverage the decline in the value of your business property to offset business income.
It only makes sense: It’s inevitable that your fixed assets will lose value over time, so why not find a way to benefit from when an asset depreciates?
Depreciation can result in a valuable income tax deduction that can save small business owners thousands of dollars each year in taxes. It’s the government’s way to support small businesses by making it more affordable for them to purchase things like buildings and equipment.
The issue: Calculating and claiming the depreciation deduction is a bit complicated. Some small business owners think they can’t do it, so they don’t take the deduction. It’s really not that hard to do and it seems such a waste to leave so much free government money on the table every year. It would make such a big difference to the bottom lines of so many businesses, especially those that have struggled through the pandemic and its aftermath.
In this article, we’ll explain everything you need to know to feel confident about calculating and taking the annual depreciation deduction, including different types of depreciation, amount of depreciation, depreciation rate, you can claim, how they work, and how to calculate them.
- Depreciation: The basics.
- Types of assets that can be depreciated.
- How depreciation works.
- Common methods of calculating depreciation.
- Section 179 deduction.
Tip: It’s always a good idea to check with an accountant or tax advisor prior to making a big change in your tax deductions or in how you calculate your taxes.
Depreciation: The basics.
So, exactly what is depreciation?
Depreciation allows businesses to reduce the value of an asset over time because of its age, wear and tear, decay, or a combination of these things, depending on the type of asset. This depreciation in value is then turned into an annual income tax deduction. The depreciation is treated by the Internal Revenue Service (IRS) as a business expense. For many businesses, especially ones that depend on a lot of costly equipment, this expense (deduction) can be a big one and significantly reduce their taxable income.
What makes things complicated is that depreciation is also the process by which a business writes off the cost of a capital asset. For example, if you spend $25,000 on a business asset, it might not make sense to claim a $25,000 expense for the asset for the tax year that you purchase it. Instead, you’d depreciate the asset over time, claiming the value as it’s lost year by year until the full purchase price is claimed.
Key point: You use depreciation to lower your tax burden because you’re reducing your overall taxable income. However, it’s important to understand that depreciation does not impact the cash flow of your business or its actual cash balance on your balance sheet because it’s considered a non-cash expense.
The depreciation deduction was created as an incentive by the United States government for business owners to grow their operations by making it easier for them to afford and purchase new equipment.
Tip: You take the depreciation deduction by filing Form 4562 with your tax return.
Types of assets that can be depreciated.
Assets that are allowed to be depreciated must have the following characteristics:
- Tangible. The asset must be something that can be defined, which can include things like innovations (patents) or that live on your computer or the cloud (software). It doesn’t necessarily have to be a physical item, such as a piece of equipment or business real estate, although many things that are depreciated are actual things. Intangible assets cannot be claimed.
- Purchased. Leased or rented items don’t qualify. Only things you buy do.
- Deteriorates, declines, or diminishes. The usability and value of the asset must be reduced over time.
- One year plus of use. Only property that your business will be using for one year or more is qualified for the depreciation deduction.
- Used more than 50 percent for business purposes. An asset that’s primarily for personal use but occasionally used for business isn’t eligible.
- Not acquired from someone you’re related to or an entity you have a relationship with. You can’t take a deduction for anything purchased from siblings, spouses, parents, grandparents, children, or grandchildren, along with companies, trusts, and charitable organizations you have a relationship with.
Examples of assets that can be depreciated include:
- Equipment, such as printers, copiers, and servers
- Machinery, such as medical, packing, or manufacturing machines
- Office furniture, including desks, chairs, and shelving
- Work vehicles, including cars, trucks, and vans.
These are tangible assets that can be depreciated. As previously referenced, intangible ones that lose value over time can be depreciated, as well. Examples include patents and copyrights.
Examples of things that cannot be depreciated include:
- Land because it typically doesn’t lose value, doesn’t get used up, and isn’t subject to wear and tear
- Inventory because it isn’t a business asset, instead it’s meant for sale
- Leased buildings because they’re not owned by the business
- Supplies because even though they get used up, it’s usually very quick and the relatively low costs don’t fit the depreciation model.
In the end: The most commonly depreciated items are buildings owned by businesses, equipment, machinery, and computers. Because of their high cost, smartphones and tablets are more and more being depreciated, especially if a business owns a lot of them.
Tip: You may want to consult with a financial professional to find out the best bookkeeping or accounting software to use to support you when you decide to take depreciation deductions for tax purposes.
How depreciation works.
The easiest way to explain depreciation is by using an example.
Imagine you own a restaurant that earns $100,000 in net income this year. This is the money you made after accounting for all costs of operating your business, including operating expenses and investments. You take a depreciation deduction of $25,000 on the building you run your restaurant out of. The IRS will tax you on $75,000 worth of income instead of the original $100,000 because of the deduction. At a corporate tax rate of 35 percent, the depreciation deduction will save you $8,750 on taxes.
Common methods of calculating depreciation.
This is the part most small business owners find challenging: Determining how much of a depreciation deduction you can take on your assets.
In order to take a depreciation deduction, you must be the owner of the property, and it must meet all the criteria outlined earlier in the article.
The IRS requires that you write off the depreciation over the useful life of the asset. That’s how long you can reasonably expect it to be used as a part of doing business, within limits.
You can begin to depreciate the property once it’s in use, and you stop depreciating it when accumulated depreciation fully recovers its cost or stop using it in your business.
Here are the depreciation time limits imposed by the IRS:
- Computers, office equipment, cars and trucks, and appliances can be written off for up to five years
- Office furniture and fixtures such as desks are able to be depreciated for seven years
- Residential rental properties can be taken as a deduction over 27.5 years
- Commercial buildings or non-residential properties are allowed to be written off over 39 years
If you want to know more about depreciation schedules, check out IRS Publication 946.
To figure out how much you are able to depreciate, you need to know the original cost of the asset and how long you can depreciate it.
Once you know that, you are then able to use one of two depreciation methods:
- Straight-line method: You depreciate your property an equal amount each year over its useful life with straight-line depreciation. To come up with the amount you can depreciate each year using the straight-line depreciation method, subtract the asset’s salvage value (the amount you could earn by selling it at the end of its useful life) from its cost. Then divide that figure by the number of years in its useful life.
- Example: You purchase a computer for $1,000. It has a five-year useful life. At the end of its useful life, you expect to be able to sell it for $200 (its salvage value or current book value). Under the straight-line method, you’d be able to deduct $160 in depreciation for the computer each year.
- Accelerated method: With this depreciation calculation method, you’ll be able to take larger depreciation deductions in the first year and during the early years of the property’s useful life, with smaller ones in later years. This is the method most commonly leveraged by small businesses. You use the IRS’s modified accelerated cost recovery system (MACRS) and refer to the IRS’s percentage table guide in Publication 946, Appendix A to figure out your deductions. This is a relatively complex process, and you may want to have an accountant or tax expert help you out with it.
Now that we’ve covered basic depreciation, let’s look at another option.
Check it out: Biz2Credit‘s equipment value calculator could help you with your depreciation calculation.
Section 179 deduction.
One other deduction related to depreciation you need to know about is the Section 179 deduction. It’s named after Section 179 of the IRS Code. It allows business owners to take same-year total depreciation deductions for the total cost of an asset.
As we’ve covered, the typical depreciation expense deduction for business property is usually parceled out over time based on the useful life of the item. Instead of using the traditional write-off method, you can use Section 179 instead. It allows you to take the complete deduction for the total price of qualifying items the same year you make the purchase and start using them.
Section 179 rules require that you have to start using the asset in your business to take the deduction. For example, if you purchase a computer in December 2021 but don’t start using it until January 2022, you would not be able to claim the deduction for your 2021 taxes. You would have to wait until you file your 2022 taxes.
Similar to regular depreciation, you claim the Section 179 deduction on IRS Form 4562.
Here are two additional things you need to know about Section 179:
The deduction is reduced if you spend upwards of $2,500,000 on qualifying items.
You can take a deduction of up to $1,000,000 of eligible property. However, if you spend more than $2,500,000 on qualifying property, your deduction will be reduced dollar for dollar.
What this means: If your organization buys $2,600,000 worth of property this year, you’ll have gone over the limit by $100,000. That means your maximum Section 179 deduction will be reduced to $900,000 ($1,000,000 minus $100,000).
Your Section 179 deduction is also limited to the net income of your business for the year. You can’t deduct more money than you made.
Example: If your business has a net income of $75,000 before taking the Section 179 deduction, and you buy $100,000 worth of qualifying property, your deduction is capped at $75,000. You’re able to carry the remaining amount to next year or take regular depreciation on it.
Depreciation is something that should definitely be appreciated — and leveraged — by small business owners. It’s really not as complicated as it seems, and it may earn you a very large tax deduction that could make a nice contribution to the bottom line — and overall profitability — of your business.
Learn more: Download Biz2Credit’s ebook to find out more ways to save on your taxes.