Small business owners need to take every tax break available to them — and depreciation is one that’s often missed or misunderstood. I want to fix that with a depreciation guide for small business owners. The goal is not to overload you with technical information. Instead, I’m going to explain the following areas of uncertainty:
- What depreciation is
- What can and can’t be depreciated
- Why it’s so essential for your business
- How, exactly, to depreciate your assets
Let’s get started.
Depreciation is an accounting method.
Most assets, like a work truck or a property, depreciate in value over time. A truck is worth less once you drive it off the lot. A new property will take on wear and tear, which reduces its value in relation to its market value. We use an accounting method called depreciation to account for this.
So, depreciation spreads out the cost of an asset over its expected useful life. That way, you get a more accurate view of the asset’s value rather than recording its entire cost as soon as it’s bought.
Depreciation is a tax deduction.
So, depreciation is an accounting practice. It’s also a tax deduction, which means that the decrease in value of a given asset, which you’ve accounted for, is deducted from your business’s gross taxable income.
Section 167 of the US tax code deals with depreciation, laying out which assets are eligible and how you can claim the benefits.
There are five core qualities of an asset that make it eligible for depreciation.
To qualify for a deduction on your taxes, the asset in question must:
- be owned by the business,
- be used for your business or an income-producing activity,
- have a determinable, useful life,
- be expected to last more than one year, and
- not be excepted property.
Excepted property doesn’t qualify.
More on that last bullet point: Excepted property includes property used less than 50% for business, intangible assets like patents, property used in tax-exempt activities, and assets acquired from related parties.
Depreciate fixed assets to lower your taxes.
‘Fixed assets’ are physical items that your business owns that can be used to generate income. The four main categories of depreciable assets are machinery, vehicles, furniture, and buildings.
1. Big-budget machinery is depreciable
Some of the most common machinery deductions are:
- Computers
- Servers
- Printers
Keep in mind that the Internal Revenue Service (IRS) considers low-cost items like printer paper to be business expenses, so they’re not depreciable. If it’s an office supply, it won’t qualify.
2. Business-use vehicles are depreciable.
Cars, SUVs, and pickup trucks used for business activities can be depreciated. The 2018 Tax Cuts and Jobs Act increased the depreciation limits for these vehicles.
3. Your furniture is also depreciable.
Furniture includes office furniture like desks, chairs, and filing cabinets, all of which can be deducted over their useful life.
4. Buildings are depreciable over 39 years.
You can depreciate the value of a non-residential building you’ve purchased. For commercial real estate, the depreciation period is set at 39 years. Components of buildings, though (for example, lighting fixtures) will depreciate at a different rate.
Land cannot be depreciated.
Even though it’s a fixed asset, land can’t be depreciated because it’s got an unlimited lifespan. It won’t get ‘used up’ the way other assets will.
Land improvements can, though.
If you improve your property in terms of value and usefulness for business purposes, then it is eligible. Improvements such as parking lots, fencing, or sidewalks should all qualify. However, as always, consult a CPA before starting construction.
There are four ways to calculate depreciation.
For the purpose of this depreciation guide, we’re not going to choose the “best” method because the method you use depends on the type of asset you intend to depreciate and your tax strategy.
- Straight-line
- Units of production
- Double declining balance
- The sum of the years’ digits
Here’s a rundown of the four calculation methods.
1. Straight-line depreciation is the most common.
Straight-line depreciation spreads the cost of an asset evenly over its useful life. The formula is simple: (cost of the asset – salvage value) % useful life.
This method gives you the same depreciation expense each year, making it easy to budget.
2. The units of production method is based on usage.
Here, your asset’s usage or activity level determines the amount of depreciation expense you can claim.
It’s best for assets where wear and tear is related to usage rather than time. If you have equipment that’s more productive in specific years, this method could be useful for you since you can take more depreciation during those periods.
3. The double declining balance method accelerates depreciation schedules.
Double declining balance is an accelerated method, meaning it depreciates assets faster in the early years. It applies double the straight-line depreciation rate to the asset’s remaining value, giving you large early deductions.
4. The sum of the year’s digits method front-loads deductions.
The sum of the year’s digits gives you more considerable depreciation expenses in the earlier years of your asset’s life. It uses a fraction that reduces annually, providing a higher cost allocation when the asset is newer (and losing value faster).
It’s similar but different from the double declining balance method.
The difference is that the sum of the year’s digits method allocates depreciation using a decreasing fractional system based on the asset’s useful life. In contrast, the double declining balance uses a fixed rate.
If the above sentence confused you, you’re not alone. This stuff is complicated. That’s why it’s best to consult a CPA for help with depreciation.
The bottom line: Depreciation matters for small businesses.
It allows you to recover the cost of essential assets over time, giving you extra funds to reinvest in your business. By depreciating equipment, vehicles, and other business assets, you can reduce your taxable income each year, leading to significant savings.
In some contexts, depreciation is not going to be the ideal tax strategy.
Usually, you want to depreciate your assets when you can and lower your liability as much as possible, but there are situations when it’s better to wait. If your business is in a low-income year and you don’t need additional deductions, it could be better to hold off until a time when your income is higher.
Here’s another scenario: If you plan to sell an asset soon, you might want to avoid depreciation. Claiming it in that situation could increase the recapture tax when it’s sold, making it less beneficial.
Use IRS Form 4562 to report depreciation on your taxes.
Okay, so you’ve got a sense of which assets to report and how. Now, it’s time for the paperwork.
You’ll need to provide information about each asset on IRS Form 4562, including its cost, the date it was placed in service, and the depreciation method. Because tax rules and asset classifications can be complex, it’s wise to consult a CPA to ensure compliance and maximize your tax benefits.
Keep detailed records.
In the unlikely event that you’re audited by the IRS, you’ll want to be able to prove that your depreciation is above board. Keep records of your purchase date, cost, usage logs, and how the depreciation is calculated. If tax authorities question you, you’ll want to have the data to back yourself up.
Jeremy A. Johnson, CPA, can help your business with depreciation.
If you had trouble with portions of this depreciation guide or have deeper questions, I want to hear from you. I’m a Fort Worth-based CPA with more than a decade of experience helping businesses like yours reduce their tax liability.
Schedule a call today.
Talk Soon,
Jeremy A. Johnson, CPA