The cost of an asset can be deducted from taxable income when a business purchases an asset such as equipment or office furniture. But having the expense for large purchases in one year but not others can affect profits. This can lead to issues with shareholders and investors.
Businesses can protect their profit margins and take their losses gradually over the asset’s useful life through depreciation.
Depreciation of Business Assets
Business assets are often deducted on a business’s tax returns, reducing taxable income. These business expenses can include everything from printer paper to computers and servers. But it can be a better idea to depreciate the cost over multiple years with certain types of assets. These assets might include machinery, equipment, buildings, vehicles and furniture.
You'd use the Modified Accelerated Cost Recovery System (MACRS) to depreciate assets. Details are included in IRS Publication 946, along with tables to determine the depreciation amounts for each year. They give you the property class and convention you’ll need.
Reasons for Asset Depreciation
You don’t just depreciate assets for tax purposes. It’s actually a sound business accounting practice. It’s important to get an accurate picture of your finances as you pull data on your income and expenses each year. It can skew the numbers and make you seem more or less profitable than you are if you have large purchases in one year but not in others.
Depreciation also helps you more easily track how often you need to replace an asset. You’re able to maximize your tax deductions to keep your taxable business income in a reasonable range by replacing that computer after its five-year useful life. You’ll make sure you replace such assets often, rather than letting them deteriorate until it affects productivity.
Types of Asset Depreciation
There are two types of depreciation: straight-line depreciation and MACRS. Straight line is simpler and more straightforward. MACRS lets businesses take the biggest deduction in the early years when the asset is new and worth more. Then the deduction is gradually decreased as the asset gets some age on it.
Straight-line depreciation involves dividing the cost of the asset over its useful period and taking that amount each year. You would divide the $2,000 cost of a computer over each of the five years of its IRS-defined useful life, giving you a $400 deduction each year.
Calculating Asset Depreciation Under MACRS
Calculating depreciation under MACRS requires a few extra steps, but you can easily tackle it as long as you have your documentation on hand before you start. Use a MACRS Tax Depreciation Calculator, which you can find online. Input the information and you’ll get the numbers you need for your bookkeeping and tax forms.
Follow these steps to calculate MACRS depreciation if you want to do things the hard way:
- Note the original purchase price of the asset. This is your “basis.” Basis can also include sales tax, shipping and delivery costs, as well as installation and setup costs.
- Gather your property class, as defined on the IRS’s MACRS Depreciation Methods Table.
- Determine your depreciation method. There are multiple declining balance methods that will put the bulk of the purchase in the first year and decline as it ages.
- Choose the time of year the asset was put into service for your business. You have three options: mid-month, mid-quarter and half-year.
- You’ll use the MACRS tables to find the percentage table you need for this year’s deduction using your depreciation method and property class.
Items That Can’t Be Depreciated
Some items can’t be depreciated for tax purposes, especially if you’re operating a business using personal equipment. Here are some restrictions to note as you’re calculating your tax deductions:
- The property can’t be held for personal purposes. You can only depreciate the portion of the asset used for business purposes if you use it for personal and business reasons.
- You must own the asset.
- The asset must be used in income-generating activities.
- It must have a determinable useful life.
- The asset must have an anticipated useful life of more than one year.
The IRS also provides some exceptions to property that can be depreciated. Excepted property is detailed in Publication 946 and includes:
- Any property purchased and disposed of within the same year
- Certain term interest
- Intangible property, which includes patents, copyrights, and computer software, unless it meets certain requirements
Equipment used for capital improvements is also excepted. This equipment must be added to your overall capital improvement costs and depreciated there.
Depreciation for High-Income Years
There are times when a straight-line depreciation may be a better idea. A business that’s growing quickly and expects to have higher income in the coming years could benefit from taking an even deduction every year and prolonging the benefit.
It could pay off to take what’s known as a Section 179 deduction if you don’t expect the next few years to be as profitable. This allows you to take the full amount of the purchase as a deduction in the current tax year, up to a certain limit. That limit is $1,080,000 as of 2022.
The government incentivizes businesses to make purchases by offering a bonus depreciation for purchases made in some tax years. This is often done to help stimulate the economy. The bonus depreciation is 100 percent as of the 2021 tax year.
Limits on Vehicle Purchases
You can depreciate the expense over multiple years if you purchase a vehicle for business use or if you use your own personal vehicle for business purposes, but there’s a limit. The limit stands at these thresholds beginning with tax year 2020:
- $10,100 for the first tax year the vehicle is in service
- $16,100 for the second tax year
- $9,700 for the third tax year
- $5,760 for each subsequent tax year
Read More: Can I Claim a Leased Vehicle on My Tax Return?
Net Operating Losses for 2021
The pandemic adjusted some things for businesses, including tax filing dates. But COVID-19 also led to some adjustments in the write-offs businesses could claim. One of those is the net operating loss limitation, and the other has to do with qualified improvement property.
The Coronavirus Aid, Relief and Economic Security Act (CARES Act) revised provisions of the Tax Cuts and Jobs Act (TCJA) that limited businesses to a net operating loss of only 80 percent of taxable income. This limitation is suspended for tax years going all the way back to 2018.
The CARES Act also fixed a glitch that was introduced by the TCJA. The definition of qualified improvement property has now been included in the definition of a 15-year property instead of being a 39-year property, which made it ineligible for bonus depreciation. This has now been remedied so businesses can take bonus depreciation on improvements they’ve made going all the way back to January 1, 2018.
Read More: Define Capital Improvements
Claiming Capital Expenses
The IRS requires that certain business expenses must be capitalized rather than deducted. Capitalization often applies to startup costs and improvements that you make to your business. They’re defined as investments you make that show value over time.
An example of a capital expense is improvements you make to one of your retail locations. You’re making an investment in the future earnings of your business by spending money on those improvements, which could include new signage, replacing the flooring or building shelving that will help increase your display space. Unlike an expense that leaves your company as soon as the purchase is made, the money you’re investing is staying within the business. It will hopefully be recouped with the increase in revenue it will bring.
Depreciable assets aren’t the only thing your business can deduct on your taxes each year. There are plenty of smaller expenses you can take in the year that you accrue them. The expense must be ordinary and necessary to be deductible.
Ordinary means that the purchase must be something that's commonly accepted in the type of business you’re doing, such as printing costs for menus for a restaurant. Necessary means that it helps your business in some way.
It’s important for businesses that sell products to deduct the “cost of goods sold” each year. You can do this by valuing the inventory you hold at the beginning of the tax year, then deducting that amount from your gross receipts to determine the year's gross profits. Small businesses can claim inventory the same way they would non-incidental expenses.
Other types of deductible expenses that can be claimed without depreciation include:
- Employee and contractor pay
- Marketing expenses
- Professional memberships
- Rent for business-related property
- Phone and internet costs
- Interest on borrowed funds
- Business insurance
- Postage and office supplies
- Travel expenses
There are a variety of options for deductions, whether you decide to depreciate over multiple years or take the full amount outright. It’s important to make sure you’re claiming deductions in a way that not only gives your business the best tax outcome but also helps you keep your books well-organized and your investors and shareholders happy.
- IRS: Topic No. 704 Depreciation
- IRS: Publication 946 (2020), How To Depreciate Property
- IRS: IRS Issues Guidance on Section 179 Expenses and Section 168(G) Depreciation Under Tax Cuts and Jobs Act
- Section179.org: Section 179 at a Glance for 2020
- IRS: IRS Finalizes Regulations for 100 Percent Bonus Depreciation
- IRS: Topic No. 510 Business Use of Car
- IRS: Publication 536 (2019), Net Operating Losses (NOLs) for Individuals, Estates, and Trusts
- BDO: Cares Act Fixes the Retail Glitch to Make Qualified Improvement Property Eligible for Bonus Depreciation
- IRS: Examination of Returns and Claims for Refund, Credit or Abatement; Determination of Correct Tax Liability
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.