Long-term assets like computers, machinery, and other business equipment can be written off on your taxes via depreciation. But when should you depreciate an asset rather than expense it on your taxes?
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Tax season is stressful as is. Throw in confusing terms like depreciation and it’s enough to make someone run in the other direction. Luckily, depreciation sounds a lot scarier than it is.
Depreciation is simply a way for businesses to write off certain purchases and assets. We’ll explain exactly what depreciation is, how it works, and when to use depreciation over standard deductions in this complete tax guide.
What Is Depreciation?
Depreciation is a method of writing off an expense over a period of years rather than all at once with a typical tax deduction. Depreciation is used for purchases and expenses that are considered long-term assets, meaning their usefulness lasts longer than one year.
For example, a computer is a long-term asset because it is useful for multiple years, whereas a purchase like computer paper is a short-term asset because it will be used up within one year. In tax season, a business could use depreciation to write off the computer and a standard deduction to write off the computer paper.
By writing off an asset over time, businesses get a tax break for each year of the asset’s useful life, until the asset hits its salvage value (salvage value is the remaining value of an asset after it has reached its useful life).
Common Assets That Can Be Depreciated
Depreciation only applies to tangible assets with a useful life of more than one year. Here are several examples of common depreciable assets:
- Computers
- Technology
- Machinery
- Equipment
- Vehicles
- Office furniture
- Property buildings
- Property improvements
- Livestock
When To Expense VS Depreciate An Asset
Depreciation is a method of deduction, but when do you use depreciation over a one-time deduction?
Businesses should depreciate a purchase if the asset’s useful life is greater than one year. By contrast, you must “expense” a purchase, or take a one-time write-off, if the asset will be used up within one year.
Businesses should also consider depreciation if they own property. Property can be deducted through a process called cost segregation and can shorten the traditional 27.5-year or 39-year lifespan periods of real estate to 5, 7, or 15 years, resulting in serious tax savings. Learn more about how cost segregation works or connect with a cost segregation company directly to see if you qualify for this deduction.
How Does Depreciation Work?
There are multiple methods and formulas used to calculate depreciation. The IRS also has very specific depreciation rules, percentages, and limits depending on the type of expense being depreciated.
For example, not every depreciable asset is a 100% deduction; some have limitations and businesses can only write off a certain percentage outlined by the IRS.
We’ll cover the basics about the different types of depreciation to get you started, but the best way to understand the detailed ins and outs of how depreciation works for each of your business’s assets is to talk with your accountant.
Types Of Depreciation
There are four to five depreciation methods (some accountants count declining balance depreciation and double-declining balance depreciation as one method, while others count it as two separate methods).
All depreciation methods require the asset’s salvage value. Salvage value is the amount an asset is worth at the end of its life and uses this formula:
Salvage Value = Purchase Cost – (Depreciation Percentage x Total Years of Useful Life)
Once you know the savage value of your asset, you can use one of the five depreciation methods to depreciate your expense — or, if you’re content enough with the general knowledge of how expenses are depreciated and would rather leave the nitty gritty details to your accountant, we don’t blame you! Scroll on to read for more depreciation basics business owners should know.
Straight-Line Depreciation
Straight-line depreciation equally distributes the same amount of depreciation for every year of the asset’s useful life.
This method of depreciation is the easiest to calculate and is a good fit for assets that have a relatively consistent usefulness throughout the asset’s entire useful life.
Straight-line depreciation is calculated using this formula:
Straight Line Depreciation Amount = Purchase Cost – Salvage Value/Total Years of Useful Life
Declining Balance Depreciation
Declining balance depreciation is a method of accelerated depreciation where an asset’s value is higher during the earlier years of its useful life and declines as the asset gets closer to its salvage value.
Declining balance depreciation allows businesses to get a larger tax break during the more useful years of an asset’s life and smaller tax breaks as the asset’s usefulness declines. This method of depreciation is helpful for purchases like vehicles which lose value quickly.
Declining balance depreciation is calculated with this formula:
Declining Balance Depreciation Amount = Current Book Value/Total Years of Useful Life x 100%
Current Book Value is calculated by starting with the purchase cost and subtracting the depreciation amount each year. For example, if you have a $20,000 asset being depreciated for four years with the declining balance method, your calculation for the first year is going to be $20000/4=$5,000 x 100%=$5000. The next year, instead of using the original purchase cost, the current book value would be the purchase cost ($20,000) minus the previous year’s depreciation amount ($5,000) for a current book value of $15,000.
Double-Declining Balance Depreciation
Double-declining balance depreciation is similar to declining balance depreciation where an asset’s value is higher during the earlier years of its useful life and declines as the asset gets closer to its salvage value. The difference is that double-declining depreciation has a more exaggerated rate of acceleration.
Double-declining balance depreciation is helpful when businesses have assets where the usefulness is frontloaded to the early years of its life and when businesses want to maximize their tax return for purchases that are too big to qualify for a one-time expense deduction.
Double-declining balance depreciation is calculated with this formula:
Double-Declining Balance Depreciation Amount = Current Book Value/Total Years of Useful Life x 200%
Sum-Of-The-Years Digits Depreciation
The sum-of-the-years digits depreciation method is another accelerated depreciation method used for assets that have a higher value during the earlier years of the asset’s useful life; that value declines as the asset gets closer to its salvage value. The main difference between the sum-of-the-years digits depreciation method and the declining balance depreciation method is that the sum-of-the-years digits method is calculated against the asset’s original purchase cost, not the assets’s current book value.
So why does that matter?
The sum-of-the-years digits method can be arguably more accurate and leaves room for partial-year calculations. However, the IRS doesn’t give a straight answer on the difference in benefits between the two, and neither do most accountants. Whichever accelerated method you choose will work well for assets that are more helpful in the early years and less helpful in the later years.
Sum-of-the-years digits depreciation is calculated with this formula:
Sum-Of-The-Years Digits Depreciation = Remaining Useful Life/Sum of the Total Years of Useful Life X Purchase Cost
Units of Production Depreciation
Units of production depreciation is a method commonly used in manufacturing. It bases an asset’s value on the number of units it produces over the course of its useful life.
This type of depreciation is a good fit for machinery and equipment where tangible products are created using the asset and the product count can be taken each year.
The formula for calculating units of production depreciation is:
Units Of Production Depreciation = Number of Units Produced x Depreciation Per Unit
To get the depreciation per unit cost, you’ll need to use this formula:
Depreciation Per Unit = Purchase Cost – Salvage Value/Expected Number of Units Over Useful Life
What Is Bonus Depreciation?
Bonus depreciation lets businesses claim an extra bonus allowance during the first year a depreciable asset is purchased. Bonus depreciation is typically allowed for property purchases (it’s worth noting that while property buildings are depreciable, land isn’t because land doesn’t lose value over time).
What Is Accumulated Depreciation?
Accumulated depreciation is the total amount of depreciation that an asset has accrued so far in its useful life since the asset was originally purchased.
What Is Recoverable Depreciation?
Recoverable deprecation is the difference between an asset’s actual cash value (ACV) and the cost of replacing that asset.
The term recoverable depreciation is heard most often when it comes to property insurance or homeowner’s insurance.
Is Depreciation Different Than Amortization?
Depreciation and amortization are two different processes used to write off assets. The difference is that depreciation is for deducting tangible assets over a period of multiple years, whereas amortization is a means of deducting intangible assets over a period of years.
How To Calculate Depreciation
To calculate deprecation you’ll need to know the purchase cost of the depreciable asset, the salvage value of that asset, the depreciation method you want to use, and the calculation formula for your selected deprecation method. Each method is calculated slightly differently to get your yearly depreciable amount.
You’ll also need to carefully understand the IRS’s rules and regulations regarding your specific depreciable asset. Sounds complex right?
The actual depreciation formulas are fairly simple, but the ins and outs of choosing between depreciation methods and understanding the IRS’s detailed tax codes are not. Depreciation is not for the faint of heart.
While it’s important for business owners to understand the basic principles of depreciation, we highly recommend you leave the actual depreciation calculations to a professional accountant or tax preparer. This will save you time and give you serious peace of mind that your deprecation calculations are correct– and that your business is getting the best tax return possible this tax season.
And don’t forget to check out our complete list of business tax deductions and business tax credits to make sure you’re maximizing your tax return.
