What business owner doesn’t want to save money on their taxes? You can pay less every year by deprecating your assets. Depreciation can seem confusing, but once you grasp how it works and see the benefit for your bottom line, you’ll be happy spending the extra time on bookkeeping.
Follow this guide to better understand depreciation, and start reducing your annual tax burden.
What Is Depreciation in Business?
Simply put, depreciation is an accounting tactic in which you can reduce an asset’s value.
The IRS defines depreciation as “an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property.” It’s a method of spreading out an asset’s cost across several years of tax returns, rather than deducting the total cost in the year the asset is purchased.
Understanding Depreciation Terms
To calculate depreciation for tax purposes, you need to know these terms:
- Useful life – the period of years an asset is expected to be usable
- Depreciation period – the amount of years over which an asset is depreciated, equal the useful life
- Salvage value – the value of an asset at the end of its useful life
- Depreciable base – an asset’s total cost minus its salvage value
- Depreciation rate – the annual percentage at which an asset is depreciated
- Accumulated depreciation – the amount an asset has depreciated over a given period of time
- Carrying value – the remaining value of an asset for the remainder of the depreciation period
How Does Depreciation Work?
The concept behind depreciation is simple. It links the cost of an item to the benefit your business receives from the revenue the asset produces.
You’re allowed to report income from the asset. Additionally, you can also report an expense equal to a portion of the item’s value to reduce your taxable income during every year you use the item.
Recording expenses this way fulfills the matching principle of accounting—which dictates that expenses must be matched to the period in which they generate revenue—and allows you to recover the cost of assets over time.
To qualify as depreciable, an asset must be:
- Expected to have a useful life of more than one year
- Something you own, including items you’re currently paying off
- Be producing income for or actively used in your own business
- Something that will lose value over time by becoming obsolete, being used up or suffering wear and tear
According to these principles, you can depreciate business property like equipment, machinery, vehicles, furniture and buildings. Personal property, investments and inventory can’t be depreciated.
Assets stop depreciating once the depreciable base has been recovered or when:
- Retired or abandoned
- Sold or exchanged
- Converted to personal use
In short, you can get a tax break on an asset as long as it’s able to serve a useful purpose in your business.
How to Calculate Tax Depreciation
Business owners have the choice of several depreciation formulas to calculate what percentage of the total cost to deduct on annual tax returns. Each of the main depreciation types provides slightly different benefits. Before starting the process, be sure to compare the following popular formulas to find the appropriate option for your industry and the asset type.
If you’re not sure which depreciation method to use, refer to IRS Publication 946. This extensive instruction booklet covers all the details of depreciation and notes when assets require specific depreciation formulas. Depreciation types are grouped under the modified accelerated cost recovery system (MARCS), and divided into the General Depreciation System (GDS) and Alternative Depreciation System (ADS).
Be sure to consult with your accountant or tax advisor about which approach makes sense for your business.
Straight Line Depreciation
Estimate the value of the asset at the end of its useful life, and subtract this value from the initial cost. Divide the result by the years of useful life listed for the appropriate asset class in Publication 946. The final number is the amount of depreciation you’ll record each year.
Double Declining Depreciation
Accelerate depreciation to deduct a greater percentage of an asset’s cost in the earlier years of its life by doubling the depreciation rate. Create a depreciation schedule with the full value of the asset recorded in the first year and the salvage value in the last year.
Divide the cost by the useful life to determine the percentage of depreciation per year. Every year, multiply the carrying value of the asset by this percentage. Then, record the result as the total depreciation for that year.
To calculate depreciation using a fraction, add all the digits of the asset’s usable life (ex: 3 + 2 + 1 for a three-year asset), and use the sum as the denominator.
Then, divide the remaining years of useful life by the sum of the total years’ digits to find the depreciation rate. For example, depreciation in the first year of a three-year asset would be 3/6, or 1/2, of the depreciable base.
Units of Production
This method is most useful for manufacturing equipment expected to produce a specific number of units during its life. Divide the depreciable base by the estimated total number of units to find the per-unit depreciation rate.
Then, multiply the actual number of units produced in a given year by the per-unit rate to get the total depreciation for that year. Alternatively, you can divide the actual units by the total estimated units and multiply the result by the depreciation base.
Regardless of the formula you use, the total amount you depreciate must equal the depreciable base of the asset. Double-check your math to make sure you don’t run into the salvage value by mistake. This may require adjusting the amount of depreciation in the final year when using the double declining method.
Record annual depreciation as a debit in a dedicated expense account, and add each year’s expense to an asset account for accumulated depreciation. As the amount of accumulated depreciation increases, it reduces the total value of your company’s assets on your balance sheet. Fully depreciated assets stay on the balance sheet until they’re no longer in use, after which you debit the accumulated depreciation and credit it under the appropriate asset.
Because depreciation calculations can be complex and confusing, it helps to work with an accountant or bookkeeping service. Professional guidance and insight ensure you get the full benefit of the depreciation process by helping you avoid errors in your books and on your taxes.
Want to Buy New Equipment (And Write Off Your Taxes in the Process)?
Although depreciation allows you to spread the cost of assets out over a period of years on your taxes, you still need to have cash to cover the full price when purchasing something new.
Financing can provide your small business with enough cash to invest in big-ticket items like vehicles, equipment and electronics. National Business Capital offers the best equipment financing programs to give you access to up to $5 million in funding in as little as two days.
If you’re expanding or adding another location, you can use capital from a small business loan to buy the property, furnishings and other basics you need to get everything up and running.
Since you can depreciate all of these assets, you can spread out payments over the terms while balancing the cost of your assets with the revenue generated.
Connect with a Business Financing Advisor at National for more details on how to get the money you need to invest in the best assets for your small business.