Running a business can get expensive when you have to purchase costly equipment, but do you realize that much of what you buy to run your business has some tax benefit in the form of depreciation?
Essentially, depreciation lets you recover the cost of what you’ve paid for certain business assets. It covers the wear and tear and deterioration of things like machinery and equipment.
What Qualifies as a Depreciation?
Things like vehicles used for business purposes, equipment, furniture, buildings and machinery can be depreciated on your business income taxes. Also some intangible property like copyrights, software and patents may be depreciable.
Here’s the lowdown on determining whether something qualifies for a tax depreciated asset:
- You (the taxpayer) own the property. If you lease property, however, you can depreciate capital improvements on it.
- The asset must be used in your business. If you use it for personal and business purposes, you can deduct depreciation only for the percent of the asset used for business.
- The asset must have a useful life of over one year.
What Can’t Be Depreciated?
There are a few exceptions to the requirements above. For example, if you have equipment used to build capital improvements or property that was put into use and then disposed of in the same year, neither of those scenarios qualify for depreciation.
You can’t depreciate land you own, but if you make improvements like building roads or adding landscaping, you can depreciate them over 10-20 years, depending on the specifics.
Types of Depreciable Assets
The type of asset you have will determine the number of years you can depreciate it.
Assets like tractors, certain livestock and manufacturing tools are considered three-year property. Computers, business vehicles and office equipment can be depreciated over five years. And office furniture, appliances and assets that aren’t categorized any other way are seven-year property examples.
Figuring Out Depreciation
There are a few ways you can depreciate your qualifying assets on your taxes. The first is straight-line depreciation. This is the default method, and the simplest to figure out.
To determine your depreciation rate, you start with the amount you paid for the asset, then subtract the estimated salvage value from that expense number. Then you need to determine the estimated useful life of your asset. Once you have that number (in years), divide that number by one to get your straight-line depreciation rate. Finally, multiply that depreciation rate by your asset cost minus salvage value.
Here’s an example: you pay $2,000 for a computer. It has a salvage value of $600, so you will be able to depreciate the difference ($1,400) over the life of that computer. Based on the recovery period for computers (5 years), you divide 1 by 5 to get 20 percent, your depreciation rate. Then, multiply 20 percent times your asset cost minus salvage ($1,400) to get $280. So for the five years following your purchase of this computer, you can use the depreciation value of $280 a year.
Another method is accelerated depreciation. This one is a little more complicated, but ultimately more popular with small businesses. With it, you take a larger deduction up front, and smaller ones in subsequent years. The IRS has what’s called a Modified Accelerated Cost Recovery System (MACRS) that can help you determine your annual write-off for the deduction.
One big difference between straight-line and accelerated depreciation is that accelerated doesn’t take salvage value into account, and you may need to use what’s called the “half-year convention:” for the first year, your typical deduction would be halved, regardless of what month you started using the asset. With straight-line, you can change that first year’s depreciation based on the quarter you purchased it.
How to Know Which to Choose
So…straight-line or accelerated? While accelerated depreciation is more popular, consider where you are with your business. If you’re new to running it, you may not want to take the biggest asset deductions up front (you’ll have other deductions that can lower your taxable income, and you may want those deductions later when you’re making more money). Newbie entrepreneurs may prefer to use the straight-line depreciation method for long-term tax benefits.
One thing to know: once you choose your depreciation method for a given asset, you can’t change it later. But when you buy new assets, you can change the method.
Where Do You Claim Your Depreciable Assets?
Now that you’ve got your depreciation numbers figured out, you’re probably wondering where the heck to enter them on your taxes. There’s a specific form for that called Depreciation and Amortization (Form 4562) that you’ll need to fill out and return with the rest of your tax paperwork. On the form, you’ll be asked to describe the property you are listing, and identify which time frame you will be depreciating it over. There are questions specific to certain assets, like vehicles, that you’ll have to answer as well.
Yes, depreciating your assets on your taxes requires a little legwork, but doing so can reduce your taxable income, helping you pay a little less in taxes. That can offset some of the money you invested in the actual asset, making it a little easier to put money into growing your business!
Have you ever depreciated your assets? If not, why?