Assets age, wear out, and lose their value. Business assets like equipment, copiers, computers... assets as inexpensive as desks and as expensive as buildings 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. The warehouse where inventory is stored is considered an asset.) In general terms, assets are items that can be converted fairly 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 in order 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
- The asset must be used as part of a trade or 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; for the tax year 2014, the maximum deduction allowed has been reduced from $500,000 to $25,000. If total asset acquisitions total more than $25,000 unused deductions can be carried forward into future years. In addition, the $25,000 deduction limit is reduced dollar-for-dollar to the extent the acquisition cost exceeds $200,000. For example, a $225,000 acquisition in 2014 would not be eligible for the $25,000 deduction and would have to be depreciated, instead, over its cost recovery period.
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.
Consult an experienced accountant for guidance on depreciation techniques, allowances, time periods, and any other changes in the tax code. He or she can also help determine whether straight-line or accelerated depreciation is best.