Any business, either tangible or intangible, require fixed assets. Those assets have a lifespan of more than one year and are not easy to convert into cash such as machinery, equipment, vehicles, property and etc.
Depreciation is an income tax deduction, which lets you to spread and recover the cost of fixed assets over their usable lifespan. The same applies for intangible assets such as patents, licenses, and trademarks as well.
In addition, depreciation is used in accounting to accurately record your investment in fixed assets.
What makes an asset eligible for depreciation?
- Must be depreciable
First, you need to know what assets are depreciable and what are not. The most common depreciable assets are vehicles, commercial property, office equipment, office furniture and production machinery. They are self-explanatory.
Other than that, you may depreciate home office space, which is typically a single room dedicated towards office work.
Major repairs that result in replacing or fully restoring a fixed asset can be depreciated as well. An example would be replacing an old manufacturing machine with a brand new one that’s more efficient, fast and durable.
Assets that are not eligible to be depreciated are stock/inventory, land, leased property and minor repairs. You will soon get to know why land isn’t depreciable. An example of a minor repair would be tire replacements of your company vehicle. Such costs can be 100% expensed.
- Must be used in your business
Personal vehicles, property and furniture are not depreciable since they are not of use to your business. You can however, depreciate the assets within your home office space.
You are able to depreciate assets used for both personal and business purposes as well. Here, the income tax deduction will be limited to the time assets were actually used in the business.
For example, say that you use your car for both personal and business purposes. The depreciation amount will depend on the percentage of time the car was used for business purposes each year and you would need a way to prove it.
In such cases, a mileage tracker that allows you to separate your personal and business journeys would come in handy.
- Must be owned by you
You are considered the owner of an asset regardless of how you paid for it, through cash, card or loan. One exception is the ability to depreciate leased property if it meets certain conditions as specified in the IRS Pub 946.
- Must have a lifespan of more than 1 year
An asset is not depreciable if it wears out or becomes unusable within the first 12 months. You are not required to depreciate such assets in accounting books because 1-year assets are often cheap, and therefore has little to no impact on your financials.
- Must wear out
If an asset doesn’t get worn out or become obsolete, they are not eligible for depreciation. That’s why land can’t be depreciated. In other words, a depreciable asset must have a finite lifespan.
Depreciation as a tax deduction
The IRS doesn’t allow you write off the entire cost of fixed assets immediately. You will only be able to deduct a portion of the initial cost each year, until either the cost is fully recovered, or the asset is no longer adding any value to your business.
For example, say you bought an elevator for $50,000. You will then be able to recover the cost of the elevator over its estimated lifespan by deducting a portion of its cost from your taxable income each year.
You can use one of the three methods listed below to calculate how much you are able to deduct from your income tax each year.
- Straight-line depreciation
You can use straight-line depreciation to calculate the tax deduction from your intangible assets such as patents, trademarks, licenses and software. Here, the same amount is written off each year of the asset’s usable lifespan.
- MACRS
MACRS or Modified Accelerated Cost Recovery System is the most widely used method for calculating depreciation. Here, a sizeable portion of the cost is depreciated in the early years of the asset’s lifespan than at the end.
- Section 179 deduction
If one or more of your assets qualify for a section 179 deduction, you’re really lucky, because then you will be able to recover the full cost of those assets in the year you purchased them itself.
You won’t have to spread the cost over the number of usable years of the asset, and instead, you could just deduct the entire amount from your income tax, considering the value of the asset is less than or equal to $500,000.
If the cost is greater, simply deduct $500,000 in the year of purchase and recover the remainder using the MACRS method.
Depreciation in accounting
Now let’s move to the accounting side of depreciation. Recording depreciation expenses in accounting books is not necessary when purchasing a single inexpensive asset.
However, not recording depreciation for multiple expensive assets may really throw off your books and will make your business look less prosperous than it actually is.
Take the elevator example from before. Say that you had a revenue of $120,000 and an expense of $85,000 before purchasing the elevator. The net profit here would be $15,000.
If you decide not to use depreciation and record the entire cost of the elevator as an expense, you would end up getting a $35,000 negative balance in your profit and loss statement, instead of a $15,000 profit.
It doesn’t matter whether or not you depreciate assets in accounting books. You will still have spent $50,000 on the elevator. So nothing changes from an actual cash-in-hand point-of-view.
The only downside of not depreciating your assets in accounting books is, financial statements such as profit and loss statement and income statement may show how bad your business is performing, even though its actually doing great.
The $35,000 loss doesn’t account for the fact that the elevator will be of use to the business for a long period of time.
If you had depreciated it, the expense for the elevator would have been much lower, and therefore, could have avoided or at least minimized the loss on your profit and loss statement.
The $35,000 loss would negatively impact your ability to take on loans or acquire investors as well. You don’t want them to think that your business is falling apart when it’s actually not.
The four methods you can use to calculate depreciation for accounting purposes are Straight Line, Double Declining Balance, Sum of the Years Digits, and Units of Production.
Lets move past straight-line method since we already covered it in the tax depreciation section.
- Sum of the Years Digits
This is the equivalent of MACRS, for accounting purposes. It lets you write off more of the asset’s cost in the early years of the business rather than the end.
- Double Declining Balance
This allows you to recover an even larger portion of your asset’s cost in the early years than Sum of the Years Digits.
- Units of Production
Here, depreciation is calculated based on the number of units an asset is able to produce in a given year.
Choosing a method for tax purposes
We discussed the various methods used to calculate depreciation for both tax and accounting purposes, but which of them should you actually use? The answer may vary depending on the asset.
Take a generator for example. Straight-line depreciation is not an option since it’s only usable for intangible assets such as licenses and permits. MACRS would be a better choice since it lets you depreciate more of the cost during the early years.
That said, if the generator qualifies for Section 179 deduction, you are able to depreciate up to $500,000 in the year of purchase itself. And for the most part, it would mean recovering the entire cost of the asset.
Choosing a method for book purposes
Personally, I prefer straight-line depreciation because of how easy it is to calculate depreciation and because you can then use one method for both tax and accounting purposes.
Once you figure out the depreciable amount for the first year of an asset, it’s the same for every other year.
Say you recently bought a machine for manufacturing purposes. The most accurate way to calculate depreciation here would be Units of Production method. Here, depreciation is calculated based on the number of units produced by the machine each year during its lifespan.
However, for assets that loose their value much quicker in the early years such as cars and computers, Double Declining Balance or the Sum of the Years Digits would be better choices.
What is a depreciation schedule?
It’s highly recommended to create a depreciation schedule containing prominent information such as the name, cost and lifespan of the asset, the date it was placed in service and the amount depreciated in each year for both tax and book purposes.
A sample depreciation schedule based on straight-line depreciation is shown below.
| Date put into service | Asset | Cost | Lifespan (years) | Year-1 (tax) | Year-1 (books) |
| 01/05/2018 | Generator | $10,000 | 5 | $2,000 | $2,000 |
| 23/05/2018 | A/C unit | $5,000 | 5 | $1,000 | $1,000 |
When does depreciation starts and stops?
Most people think depreciation starts immediately after purchasing an asset, but that’s simply not true. For example, say you bought a large conference table from an overseas company on June 1st.
It gets shipped immediately but shows up in your premises on June 15th. Even then, you need to unbox, unwrap, put the table’s legs in position (considering it was shipped with legs detached), and find a suitable place for the table.
All this may take 1-2 days depending on how busy you are. Once set up, the date would be around 17th of June and that’s the date where depreciation starts.
Depreciation starts after the asset is actively available for use in your business and stops when you have either recovered the asset’s entire cost or it’s no longer usable, whichever happens first.
Say you bought a computer for $2,000 and its useful lifespan is 4 years. You would then depreciate $500 each year until its cost is fully recovered. At the end of the 4th year, you will no longer be capable of depreciating the computer.
You have to stop depreciating your asset once you retire it from service. Generally, retiring an asset refers to when the asset is no longer usable in your business.
Some other reasons for an asset’s retirement are selling, exchanging or abandoning the asset. The same holds true when converting an asset from business use to personal-only use.
How an asset’s cost is calculated
The cost of an asset isn’t just its price tag. It includes everything you had to spend from purchasing it to actually placing it in service.
Say that you purchased a machine worth $20,000 from a foreign company. Even though you paid for the asset in full, other expenses such as shipping fees, transportation charges, and tax need to be accounted for as well.
In addition, you may need to add new wiring to accommodate the machine in your office space. This will cost you money as well. All these expenses must be accounted for when determining the cost of an asset.
How to determine the lifespan of an asset
The useful lifespan of an asset refers to the number of years a particular asset can be of use to your business and not the number of years the asset will last.
You can’t just randomly come up with a lifespan. There are many factors that influence the lifespan of an asset such as the age of the asset, quality, frequency of use and the condition of the place it’s installed in.
Don’t bother to estimate the lifespan of your assets yourself. The IRS has done the work for you and included the recovery periods for all depreciable assets in Publication 946.
What’s the salvage value of an asset?
The salvage value is the estimated worth of an asset at the end of its lifespan. It tells you how much you can sell the asset for, after you are done using it. It may be greater than the asset’s original price or may even be zero.
The salvage value depends on the nature, lifespan, demand and how frequently new versions of the asset get released. The value may be even greater than the asset’s original price or may even be zero.
You can’t depreciate the asset any further than its salvage value. If you sell the asset for more than its estimated salvage value, it’s a profit, otherwise it’s a loss.
What’s the book value of an asset?
The book value or the carrying value of an asset is its cost at the end of each depreciated year. For example, say you bought a computer worth $3,000. It has a lifespan of 4 years and a salvage value of $500.
This means, at the end of the 4th year, the computer would be worth $500 and you may sell it.
Assuming you are using straight-line depreciation, the formula to determine the yearly depreciable amount is as follows.
(Initial cost - salvage value) / lifespan (years) = Yearly depreciable amount
In the case of our example, it would be;
($3,000 - $500) / 4 = $625
So each year you are able to deduct $625 from your taxable income, until the asset reaches its salvage value. For example, at the end of the first year, your computer’s book value would be $2,375 ($3,000 – $625), and $1,750 at the end of the second year.
How to claim tax deduction for depreciation
There are three ways to calculate the tax deduction for your fixed assets; MACRS, straight-line and section 179. However, to actually claim it, you would need to complete and submit Form 4562 for each depreciable asset you own. Those forms must be submitted along with the tax return document.
How to handle tax return errors
You must double check your tax returns before filing them to avoid any problems or confusions in the future. But sometimes, mistakes ought to slip your eyes.
In such cases, you can simply file an amended tax return with all the corrections in place. However, depending on the mistakes and alterations, you may be required to file Form 3115 in addition to the amended tax return.
The most common mistakes seen on tax returns are, depreciating non-depreciable assets, incorrect estimation of an asset’s lifespan and incorrect calculation of an asset’s depreciable amount.
How to record depreciation in books
When recording depreciation in accounting books, add a depreciation expense account and accumulated depreciation account to your accounts list. Then debit the depreciation expense account and credit the accumulated depreciation account for each of your fixed assets.
The debit entry here will increase the expenses in the profit and loss statement and the credit entry will decrease the net value of all fixed assets in the income statement.
How repairs are handled in depreciation
There’s no guarantee that fixed assets can be used without having to repair them somewhere along their lifespan. Things do break or stop working sometimes, and depending on how big the repair is, you may be able to depreciate it.
For example, a major repair that involves replacing most of the hardware on one of the computers, can be depreciated since new parts holds value, however, a minor repair like fixing the A/C cannot.
Conclusion
Depreciation lets you recover the cost of your fixed assets over their useful lifespan, and therefore, isn’t an immediate cost recovery strategy.
The only exception is if your asset is eligible for a Section 179 deduction, letting you recover up to $500,000 of its cost in the year of purchase itself. For most assets, this could mean recovering the entire cost at once via income tax.
Keep in mind, not all assets are depreciable. For an asset to be depreciated, it has to have a lifespan of more than one year, wear out at some point of time, owned by you and used for business purposes. Some leased property can be depreciated as well.
By now, you probably know how important it is to record depreciation expenses in accounting books and how it impacts your ability to secure a bank loan or an investment in the long-run.
Hopefully, now you understand how important depreciation is to a business. If you have any questions, let me know in the comments section below.
