How Does Depreciation Affect Business Taxes?

small-business-tax-planningPeople are often confused by depreciation. When you purchase a capital asset in business (e.g., computer servers, furniture, buildings, etc.) it has what’s known as a “useful life”, which means that it wears out or becomes obsolete over time.

Depreciation is the way businesses pro rate that expense, so that some of the tax deduction occurs in future years. The IRS has a schedule that details how many years to depreciate each type of equipment. For instance, a building is depreciated over a much longer time frame than a piece of machinery because one wears out sooner than the other.

Fixed Assets Depreciate

All businesses require operating equipment of some kind; some also require warehouses or vehicles.  These types of assets have useful lives of longer than a year and are known as “fixed assets”.  Since these items help your business to make money over a period of future years, the idea is to pro-rate the expense and tie it more closely to the time frame of the actual revenue it has helped you to earn.

To reduce recordkeeping, many businesses set a dollar limit, usually in the $500 – $2,500 range, to determine whether an item will be expensed entirely in one year or depreciated over several years.  This annual deduction is also subject to the overall limits that can be deducted in any given year per IRS regulations. Your accountant can help you set a per item limit that is reasonable for your business. 

What Items Cannot be Depreciated?

Land is not depreciable, as it never is “used up.”  So undeveloped real estate is not depreciable, nor is inventory that you plan on leasing or renting.  However, improvements made to land, such as a building, are depreciable. In addition, intangibles (like trademarks and licenses) are not depreciable.  And taxpayers are not allowed to depreciate personal assets used outside of the business; e.g., family vehicles or personal PCs. 

How Is Depreciation Calculated? 

There are two primary ways: Straight-line and Accelerated Cost Recovery System (ACRS). You can choose the depreciation method to be used for each item.  Straight-line gives you an equal depreciation deduction in each year and ACRS front end loads the deduction by taking more in the early years and less later on. Both methods allow you to ultimately depreciate the same dollar amount.  For example, an item with a 10 year life and a $1,000 purchase value, would be depreciated $100 per year for ten years. Under one of the ACRS calculations, it would be more in the first year and then declining amounts for the following years. 

How Does This Impact Your Business Taxes?

It alters the time frame when you get the tax deduction. If something costs $1,000 and is expensed in the first year (i.e., not depreciated), you have a $1000 tax deduction. If the same item is depreciated using the straight-line method, you would have a $100 tax deduction in the first year & $100 in each of the following 9 years. Depending upon the amounts involved, this can have a significantly different tax deduction impact, so it’s important to understand which is the best way to use to reduce your taxes.

The IRS has more information on how to handle property depreciation or check with your accountant.

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