Assets age, wear out, and lose their value. Business assets like buildings, equipment, office furniture copiers, and computers are considered, for tax purposes, to have a finite useful life. Because their useful life is finite, the IRS allows you to, over time, recover the cost (or the basis) of qualified assets.
What qualifies? Most tangible assets can be depreciated. An asset is a tangible item that is considered a business resource. For example, items in inventory are not considered assets; they are goods to be sold. However, the warehouse where inventory is stored is considered an asset. In general terms, assets are items that can be converted readily into cash if sold. (The words "fairly readily" apply to assets like equipment, because some specialized, expensive machinery may take considerable time to sell.)
Quick note: Land is not considered an asset that can be depreciated. (Land does not age or wear out.)
Here is a brief example of depreciation in action. Say a company manufactures a variety of automobile parts. A new piece of equipment is purchased. Since the equipment is an asset used in normal operations, it can be depreciated. The IRS assumes the equipment will lose some amount of value each year - because almost all assets do - so you are allowed to deduct that value through depreciation. Once the asset is fully depreciated it can remain in service, but you will not be allowed to claim further depreciation as an expense.
Because depreciation is considered an expense it is listed under Expenses on the Income Statement.
Depreciation amounts are calculated using two key numbers: The initial cost of the asset, and the useful life of the asset. Here is a breakdown of some of the useful lives of different categories of assets:
- Three Year: Manufacturing tools, farm equipment, and other "light" assets
- Five Year: Office equipment, computers, vehicles, light construction equipment
- Seven Year: Office furniture, appliances
- Thirty-Nine Year: Non-residential buildings and facilities
The above is a partial listing of allowable asset life; a full breakdown can be obtained from the IRS website or from your accountant.
The IRS allows three main methods of depreciation. Here’s a brief look at each.
Straight-Line Depreciation: Straight-line depreciation is the simplest method used to depreciate assets. Divide the initial cost of the asset by its useful life to determine the annual depreciation amount. For example, if you buy a piece of equipment for $10,000, and its useful life is considered to be three years, you can deduct $3,333.33 per year. The $3,333 is then reported as an expense on the Income Statement.
Accelerated Depreciation: This method of depreciation is very popular for small businesses. Under accelerated depreciation, larger deductions can be taken in the first years, with smaller deductions allowed in subsequent years.
The most commonly used form of accelerated depreciation is called the Modified Accelerated Cost Recovery System (MACRS). MACRS allows a business to take significantly higher depreciation amounts for the first three to four years (depending on the useful life of the asset) and then a reduced amount over the remaining years. Keep in mind the total amount depreciated is the same under straight-line or accelerated depreciation; the only real difference is the timing of the expense allowed.
While many businesses use accelerated depreciation to get an expense "bump" in the first few years, a business with solid growth potential may prefer straight-line depreciation under the assumption that as revenues grow higher expense allowances in later years can help offset income and provide a better long-term tax benefit.
Keep in mind, however, that once straight-line depreciation is chosen, a company cannot switch to MACRS depreciation in subsequent years. But different depreciation methods can be used for assets acquired in following years.
Section 179 Expense Deduction
This form of accelerated depreciation allows a business to deduct the entire cost of an asset in the first year it was acquired and used for normal operations. To qualify:
- The asset must be a tangible asset, but not real estate (except depreciable tangible property used in connection with lodging, and improvements to non-residential real property)
- The asset must be used primarily for business; rental assets are typically not eligible
- The deduction amount cannot be larger than the company’s earned income for the reporting year
Maximum limits do apply; beginning in 2018, the maximum deduction allowed per year was increased to $1 million with an investment limit of a $2.5 million cap. The amount that can be deducted each year is reduced dollar for dollar by the amount your business investments (i.e., purchases of equipment) exceed the annual investment limit. The $1 million depreciation limit and the $2.5 million investment limit are indexed for inflation each year starting in 2018.
Two brief caveats:
Intangible assets that have a fixed life - like a patent that will expire after a period of time or a contractual agreement to use a copyright or trademark for a fixed period of time - must be depreciated using the straight-line method.
When you sell an asset before the end of its useful life, any depreciation claimed is subtracted from the cost basis of the asset, which could cause you to show a capital gain on the sale. For example, if you purchase an asset for $10,000, over the course of a few years take depreciation deductions of $5,000, and sell the asset for $7,000, you experience a capital gain of $2,000 even though you originally paid $10,000 for the asset.
Double Bonus Depreciation
The bonus depreciation doubles the immediate, first-year deduction on qualifying equipment from 5% to 100%. The deduction, which was due to expire in 2018 has been extended through 2026 (phase-out begins in 2023) and is now available on both new and used purchases.
Qualifying property can include personal property that is used over 50% of the time for business. With the new tax law, computers are no longer considered listed property, which means they can be used less than 50% of the time for business.
Planning Opportunities
- With some forward planning, businesses can use deductions to offset profits. For example, if you’re expecting a larger profit next year, you could consider delaying a big purchase.
- In many years, a well-planned Section 179 or bonus depreciation deduction can enable your business to retain cash to be reinvested in the business.
- The tax savings can be applied to future purchases, which could generate additional tax savings for reinvestment the following year.