If you missed the last two posts in our ongoing series about tax-deductible business expenses, check ‘em out below:
If you are a small business owner, you know how important it is to take advantage of as many deductions as possible. One oft-overlooked tax break is the depreciation deduction.
If you purchase a business asset to be used long-term in your business operations, you may be prohibited from deducting the entire cost of the asset in the same year you made the purchase. Instead of deducting the cost as a single business expense, you will need to spread the cost of the asset out over time. This process of allocating an asset’s cost and decline in usefulness over multiple years is called depreciation.
Through depreciation, a portion of the expense is deducted each year, taking into account the asset’s decline in value over time (also known as its useful life). To put it another way, depreciation represents how much of an asset’s value has been used up in a given year.
You can claim a depreciation deduction by listing this decrease in value as an expense on your business's income statement and filing Form 4562 with your tax return.
What types of assets am I allowed to depreciate?
Depreciation may be used to spread out the cost of a fixed asset over time. A fixed asset is a long-term, tangible asset used in the production of goods or services.
Fixed assets take a physical form, such as a building or piece of machinery, and are expected to last for more than a year. Fixed assets are often categorized as property, plant, or equipment (PP&E).
You may depreciate a fixed asset if it meets all of the following requirements:
You own the asset.
It is used in business or held to generate income.
It will continue to be useful beyond the year in which it is acquired.
It has a determinable useful life, meaning that it will wear out, decay, become obsolete or used up, or lose its value from natural causes.
The property is not considered excepted property, which refers to property that is acquired and disposed of within the same year.
Examples of depreciable assets include machinery, buildings, vehicles, computers, machinery, and other eligible property used in the course of business.
Can I depreciate my business inventory?
No. Although inventory generates income, it is considered a current asset rather than a fixed asset. While fixed assets are expected to last long-term, current assets are expected to be sold or used up within a single year. Current assets such as inventory are not depreciated because of their short life expectancy.
Why can’t I depreciate the cost of land?
Although land may be considered business property, it does not wear out, become obsolete, or get used up. Therefore, it does not have a determinable useful life, making it ineligible for depreciation.
However, you may be able to depreciate the cost of land improvements such as fencing, roads, or bridges. These enhancements increase a plot of land’s usefulness. Most land improvements that have an identifiable useful life are depreciable.
Can I depreciate the costs of repairs to my property?
Possibly, but probably not. Costs of repairs or maintenance cannot be depreciated unless they are considered betterments. Betterments differ from normal repair and maintenance expenses because they improve the quality or extend the life of an asset.
For example, patching a damaged roof would be considered a repair, but replacing the roof entirely would be considered a betterment. The cost of patching the roof would not be depreciable, but replacing it would meet the requirements for asset depreciation.
Although repairs and maintenance that do not improve your property cannot be depreciated, you may deduct those costs as business expenses on your tax return.
Can I depreciate the cost of my patent or copyright?
No. Depreciation may only be used with tangible assets such as real property, machinery, or vehicles. Intangible assets such as copyrights, trademarks, and patents are not generally considered depreciable.
However, you may be able to spread out the cost of intangible assets using a similar process called amortization.
Whereas depreciation takes into account a tangible asset’s declining usefulness or wear and tear over time, an intangible asset may not have an identifiable useful life. Using amortization, the costs of intangible assets such as intellectual property are spread out over a specific number of years regardless of the actual useful life of the asset.
Is there a time limit for asset depreciation?
Yes. The period of time over which an asset must be depreciated varies based on the type of property. Under the General Depreciation System (GDS), there are nine property classifications:
3-year property includes tractor units for over-the-road use (such as a semi-truck), qualified rent-to-own property, and more.
5-year property includes most vehicles, office machinery (such as calculators and copiers), certain farming machinery, and more.
7-year property includes office furniture and fixtures (such as desks), certain agricultural machinery, railroad tracks, and more.
10-year property includes water transportation equipment, single-purpose agricultural or horticultural structures, and more.
15-year property includes certain land improvements (such as shrubbery, fencing, roads, or sidewalks), certain electric transmission property, and more.
20-year property includes certain farm buildings, municipal sewers, and more.
25-year property includes certain water utility property.
Residential rental property includes any building or structure that derives 80% or more of its gross rental income from dwelling units. Residential rental property is depreciated over 27.5 years.
Nonresidential real property includes certain office buildings, stores, and warehouses. Non-residential rental property is depreciated over 39 years.
**For information on Alternative Minimum Tax (AMT), contact your tax professional.
How can I calculate an asset’s depreciation?
In order to calculate the depreciation of an asset, you’ll need a few bits of information: the useful life of the asset, the asset’s salvage value (how much you could reasonably sell the asset for at the end of its useful life), and the cost of the asset.
There are several different methods for calculating depreciation. These methods fall into two main categories: straight-line depreciation and accelerated depreciation. Accelerated depreciation is most often calculated using the double declining balance (DDB) method or by claiming the Section 179 deduction or bonus depreciation deduction.
Straight-Line Depreciation
The straight-line depreciation method depreciates an equal amount over each year of an asset’s life. This method is most suitable for assets whose value steadily declines over time.
To calculate depreciation using the straight-line method, first subtract the asset’s salvage value from its cost. Then divide that number by the number of years in its useful life.
( Cost - Salvage Value) Useful Life = Yearly Depreciation Value
For example, if you purchased a $2,000 piece of machinery with a $500 salvage value and a 5-year useful life, you would deduct $300 in depreciation each year for five years.
( $2,000 - $500) 5 = $300
Double Declining Balance Method
The double declining balance method of depreciation allows business owners to take a larger depreciation deduction during the first few years of an asset’s useful life, followed by smaller deductions in subsequent years. This method best suits assets that rapidly become obsolete, such as cell phones or computers.
Section 179 Deduction
Section 179 of the IRS tax code allows businesses to deduct the full purchase price of certain qualifying assets in the year purchased rather than depreciating the costs over a period of time. This tax incentive allows for an immediate, larger tax break for small businesses. The Section 179 deduction may be especially appealing to new business owners facing hefty startup costs.
If you claim the Section 179 deduction, your total deduction will generally be limited to $1,040,000 for property placed in service during 2020. In addition, Section 179 cannot be used to create a loss for tax purposes.
For more information on the Section 179 deduction, contact your tax professional.
Bonus Depreciation Deduction
The bonus depreciation deduction, also known as the special depreciation allowance, is a 100% deduction for the cost of qualifying property that can be taken in the first year the property is put into service. Qualifying property may include machinery, equipment, computers, appliances, and furniture used in the course of your business.
Purchases made in prior years may qualify for bonus depreciation if the purchased property had not been used until the current tax year.
Although the Section 179 deduction cannot exceed your business’s annual income, there is no such restriction on bonus depreciation; your bonus depreciation deduction may create a net operating loss.
If an asset qualifies for bonus depreciation as well as Section 179, you must claim the Section 179 deduction before applying bonus depreciation.
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