Taxpayers that own assets for business purposes may use depreciation, a type of income tax deduction, to recover the cost of assets that will lose value due to wear and tear, deterioration and/or obsolescence. Understanding how to account for depreciation and how to categorize your assets can lead to significant tax advantages.
Meeting the Requirements for Depreciation
With the exception of land, most tangible assets are depreciable. Even intangible property like patents or software can be written off as depreciations. In order to take advantage of depreciation as an income tax deduction, your assets will need to meet certain requirements:
- You must own the asset or be deducting for capital improvements to a property you are leasing.
- The asset must be used for income-producing purposes. If the asset is used for personal purposes as well, you must take this into account when calculating depreciation to make sure personal use is not included in your deduction.
- The asset must be useful for more than one year.
There are many designations for depreciation. For assets that aren’t real estate, the most common categories are three-year property, which includes some farming and manufacturing equipment and livestock, five-year property, which includes computers, office equipment, automobiles and construction materials, and seven-year property, which includes office furniture and appliances.
For real estate, residential properties depreciate over 27.5 years and commercial buildings over 39 years. You may write off land improvements, such as landscaping over periods of 10, 15 or 20 years, depending on the asset.
Straight-Line vs. Accelerated Depreciation
There are a number of ways to calculate the depreciation of your assets, and each has different advantages and disadvantages you will want to take into account. A depreciation calculator can be a helpful tool in determining an actual number.
Straight-line depreciation is the simplest method when it comes to calculating depreciation. It supplies the slowest returns but can give the best long-term benefits. Simply take the initial value of your asset, deduct the estimated salvage value your asset will have when the depreciation term is over, and split this amount in equal parts over the number of years you will be taking the deduction, also known as the product’s useful life.
Here is an example of an asset that costs $10,000, has a $200 salvage cost and has a four-year useful life:
Year 1: (10,000 – 200) ÷ 4 = $2,450
Year 2: (10,000 – 200) ÷ 4 = $2,450
Year 3: (10,000 – 200) ÷ 4 = $2,450
Year 4: (10,000 – 200) ÷ 4 = $2,450
If you choose accelerated depreciation, you will receive a larger return on your asset in the early years of its depreciation. Accelerated depreciation is useful when the productivity of an asset is greatest in its early years.
There are some important factors to take into consideration before choosing accelerated depreciation:
- Be wary of cost-segregating services that run on commission, as they may attempt to inflate your deductions for their own benefit.
- Businesses that report taxable profit will not be able to benefit from accelerated depreciation.
- If you are using accelerated depreciation on your property and sell it at a profit, it is recaptured as ordinary income and taxed at 35% instead of 25%, as is the case with straight-line depreciation.
- Make sure to keep records supporting all of your estimates in case of an audit.
Types of Accelerated Depreciation
“Sum of the years” depreciation is a form of accelerated depreciation calculated by taking into account the number of years you will be using the asset. If the useful life of your asset is 4 years and the value of your asset is $10,000, you will calculate your sum of the years depreciation like this over the 4 years:
Year 1: 4/10 X 10,000 = $4,000
Year 2: 3/10 X 10,000 = $3,000
Year 3: 2/10 X 10,000 = $2,000
Year 4: 1/10 X 10,000 = $1,000
You find 10 as the denominator because it is the sum of 4 + 3 + 2 + 1, and you begin with four because it is the total number of years for which you will be taking the deduction.
Another popular type of accelerated depreciation is “double-declining balance” depreciation. The idea of the double-declining balance depreciation is to find the percentage your asset depreciates in the first year and double it; you then use this percentage and multiply it by the remaining balance to be depreciated until the value is lower than the straight-line amount, at which point you begin to use straight-line calculation. Here is an example with the same asset that costs $10,000 with a $200 salvage value and a four-year useful life. In this case, the asset’s value is depreciating 98% over four years or 24.5% a year. Double this, and you land at 49%:
Year 1: 49 X 9,800 = $4,802
Year 2: .49 X (9,800 – 4,802) = $2,449.02
We can see here that, already in year two, the double-depreciation method is less than the straight-line depreciation method; instead of deducting $2,449.02, we would deduct $2,450, as called for in the straight-line method.