It’s tax time, and as a small business owner you should be looking to take every single business deduction you’re entitled to. One deduction you may have forgotten about is depreciation: the continual decline in the value of property, which can be used to offset income from your business.
Depreciation can lead to valuable income tax deductions that save small business owners thousands of dollars each year. But figuring out exactly how to calculate and claim the deduction is where things can get a little confusing.
What is depreciation?
Depreciation allows small business owners to reduce the value of an asset over time, due to its age, wear and tear, or decay. It’s an annual income tax deduction that’s listed as an expense on an income statement; you take a depreciation deduction by filing Form 4562 with your tax return.
Depreciation is also the process by which a business writes off the cost of a capital asset. When you spend, say, $30,000 on an asset, you wouldn’t necessarily claim a $30,000 expense upfront; rather, you’d depreciate the asset over time, eventually claiming the full cost.
Assets that are typically depreciable include buildings, computers, equipment, machinery, office furniture and work vehicles, but you might also be able to depreciate intangible property such as patents or copyrights, according to the IRS. Property that cannot be depreciated includes land (since it does not get used up and it is not subject to wear and tear), inventory (since it is meant for sale), and leased property (since you don’t own it).
“Commonly, depreciation is taken against buildings owned by the business, equipment, and even smaller items like computers and cellphones,” says Jason Reiman, a financial planner and advisor based in Tucson, Arizona.
You use depreciation to decrease your tax burden, since you are lowering your overall taxable income. But it’s important to understand that depreciation does not affect your company’s cash flow or its actual cash balance, since it’s a non-cash expense.
For example, let’s say you own a restaurant that earns $100,000 in net income this year — the money you’ve made after accounting for all costs of operating your business, including operating expenses and investments — but you take total depreciation deductions of $25,000 on the building you own. The IRS would tax you on $75,000 of income instead of $100,000 because of the deduction. At a corporate tax rate of 35%, you’d save $8,750 on taxes.
How to figure depreciation
Here comes the tricky part: figuring out how much of a depreciation deduction you can take on your assets.
In order to use depreciation as a deduction, you must be the owner of the property, and it must have a “useful life” of more than one year. The IRS requires that you write off the depreciation over the useful life of the asset. You can begin to depreciate the property once it’s in use, and you stop depreciating it when you’ve fully recovered its cost or you stop using it in your business.
Computers, office equipment, cars and trucks, and appliances can be written off up to five years; office furniture and fixtures such as desks can be written off over seven years; residential rental properties can be written off over 27.5 years; and commercial buildings or non-residential properties can be written off over 39 years, according to IRS Publication 946.
To figure out how much you can depreciate, you need to know the initial cost of the asset and how long you can depreciate it for. You can then use one of three depreciation methods:
Straight-line method: You’ll depreciate the property an equal amount each year over its useful life. To come up with the annual amount you can depreciate, subtract the asset’s salvage value (the amount you could get by selling it at the end of its useful life) from its cost, and divide that figure by the number of years in its useful life.
For example, if you purchase a computer for $1,000 and it has a salvage value of $200 and a five-year life, you'd be able to deduct $160 in depreciation each year.
Accelerated method: With this method, you’ll be able to take larger depreciation deductions in the first few years of the property’s useful life, and smaller deductions later on. This is the method most commonly chosen by small businesses, according to TurboTax.
You’d use the IRS’s modified accelerated cost recovery system (MACRS) and refer to the IRS’s percentage table guide in Publication 946, Appendix A to figure out your deductions.
Section 179 Deduction: This allows you to deduct the entire cost of the asset in the year it’s acquired, up to a maximum of $25,000 beginning in 2015.
Depreciation is something that should definitely be appreciated by small business owners. But since you’d rather spend time growing your small business than figuring out complicated tax rules, hiring a tax professional is likely a smart move.