When you hear the term "depreciation," you probably think of driving your new car off the lot and having it immediately begin to decrease in value. While it's not great to have your property lose value, there are some benefits for business owners to be able to depreciate assets by taking deductions from their cost for multiple years.
- Depreciation is a series of tax deductions taken on business assets that last more than a year, like business vehicles, buildings, equipment, and furniture.
- Depreciation allows a business to spread out the cost of these assets to lower its tax liability for those years.
- The general depreciation calculation is the asset value minus salvage value divided by the number of years of useful life.
- Depreciation can be accelerated for some types of assets, and two special depreciation types can enable a business to get additional deductions during the first year an asset is used.
What Is Depreciation?
Businesses are able to take tax deductions on expenses incurred when doing business. But for big-purchase business property, this expense is deducted over time through a process called depreciation.
Depreciation is the recovery of the cost of the property over a number of years. You deduct a part of the cost every year until you fully recover its cost.
Some depreciation terms are different for accounting and tax purposes, but they mean the same things. The terms "asset" in accounting and "property" in taxes are the same. The term "useful life" is used in accounting, but "recovery period" is used in tax situations.
Assets That Can–and Can't–Be Depreciated
Business assets that can be depreciated include equipment, machinery, technology, computers, office furniture, buildings, and improvements to these assets.
Property must meet the following requirements to claim depreciation for tax purposes: :
- You must own the property.
- The property must be used in a business or an income-producing venture.
- It must have a useful life that can be determined.
- It must last longer than one year.
Business property can't be depreciated until it is placed in service, meaning that it's been acquired and is ready and available for specific use.
You can't depreciate:
- Intangible property, like patents, trademarks, and copyrights
- Equipment used to build capital improvements,
- Property placed in service and disposed of in the same year
- Land, because it doesn't wear out, become obsolete, or get used up
Some business assets are used for both business and personal purposes. You can't depreciate your personal use of these assets. For example, if you use your car for both business and personal use, you can only depreciate the business-use portion.
Depreciation for Your Home Office
If you have an office in your home that meets IRS requirements for business tax deductions, you can depreciate that part of your home over 39 years (apartments over 27.5 years). In order to be able to depreciate your home business space, you must use the regular method to calculate the home office deduction, not the simplified method.
How Do You Calculate Depreciation?
The general depreciation calculation is:
Total cost of the asset (called "asset basis") - salvage value/number of years of the asset's useful life.
As an example, let's say a business purchases office furniture for $20,000; the furniture has a useful life of 10 years and a scrap value of $1,000. Using straight-line depreciation (explained below), the resulting $19,000 cost is divided over the furniture's 10 years of life. The business can, therefore, deduct $1,900 in depreciation in each of those 10 years.
An asset's basis includes the cost of buying the asset, transporting it, and setting it up. Improvements to an asset during the time it's depreciated can be included in the basis, but you can't include the cost of minor repairs or updates.
Useful life (called "recovery period" by the IRS) is determined based on a tax schedule set up for various types of property. The business can include a specific amount on its income tax return as an expense during each year of the useful life of the asset. This reduces the taxable income of the business.
Methods of Depreciation
Depreciation is determined by one of several methods that have been approved by the IRS. The most common method is straight-line depreciation used in the above example.
You can also use the declining balance method, which allows a business to take either 200% or 150% depreciation in each year. For example, property with a basis of $100,000 and a useful life of 10 years can be depreciated in 5 years (twice as fast) using the 200% declining balance method or in 7.5 years using the 150% declining balance method.
Your business might benefit from one depreciation method more than another, and you may not be able to use one method for various reasons, so consult with a tax professional to determine which one is best for you to use.
Depreciation for Some Types of Business Vehicles
Depreciation limits are different from other limits for luxury autos used by businesses and vehicles that are considered listed property (used for both business and personal purposes).
The depreciation limits are set depending on whether the business claims bonus depreciation (described below). A three-year depreciation period is set, with a smaller amount for later tax years in the recovery period. See your tax preparer for more details.
Special Depreciation Methods
Bonus depreciation on purchases of new, qualified business assets is 100% if acquired and placed into service after September 27, 2017, and before January 1, 2023. Businesses can write off the full cost of depreciable property such as machinery, equipment, computers, appliances, and furniture.
Section 179 deductions for purchases of eligible property is $1,040,000, with a maximum for all section 179 property for the year of $2,590,000 beginning in 2020. This deduction applies to tangible personal property used in a trade or business, and, if the taxpayer chooses, it can be used in real estate and some property improvements, such as roofs, heating, and alarm systems.
Depreciation on Leased Assets
Depreciation of a business asset has nothing to do with the way the asset was bought. But leasing an asset can affect the ability of your business to depreciate it. If your lease agreement ends in a purchase, then you can depreciate the property. However, if the lease is simply a long-term rental, then you can take the rental fee as a business deduction.
Always seek help from a tax professional so you're sure that you're using the right depreciation method for your business.
Frequently Asked Questions (FAQs)
What is capitalized cost vs. depreciation?
Business costs may be deducted as a current business expense in the current year or capitalized by recovering the costs over a number of years. When a business capitalizes costs, it adds to the basis of the asset it represents.
Depreciation is used to capitalize costs for tangible business property, like buildings, equipment, furniture, and technology that is used for more than one year.
Intangible costs like patents, trademarks, and trade secrets are capitalized using amortization, a process similar to depreciation
What is depreciation recapture and how do you avoid it?
Recapture is the process of un-deducting (taking back) special depreciation allowances before you calculate the gain on business property that you are selling or otherwise disposing of. For example, if you claim a special depreciation allowance for a property that received disaster assistance, you may have to recapture the excess benefit as ordinary income.
Another common recapture situation occurs when a business has a section 179 deduction on the property. If the business use of the property drops 50% or less, you must include the recapture amount as ordinary income and you must increase the basis of the property by the recapture amount.
To avoid having the recapture the deduction, be sure to keep your business use of section 179 property above 50%.
Which depreciation method is the most common among businesses today?
Straight-line depreciation is the default method, and it's the one used by most small businesses. This method spreads the cost of the asset in equal amounts for each year of its useful life.
Two accelerated depreciation methods are allowed, called "declining balance." A 200% declining balance depreciation will depreciate the asset twice as fast, and a 150% declining balance method will depreciate the asset one-and-a-half times as fast. Both of these accelerated methods have qualifications, so check with a licensed tax preparer to make sure you can take accelerated depreciation.