When a business purchases an asset such as office equipment or office furniture, the cost of the asset can be deducted from taxable income at tax time. But for larger purchases, having the expense in one year and not others can affect profits, leading to issues with shareholders and investors. Through depreciation, businesses can take the loss gradually, over the asset’s useful life, and protect their profit margins.
Depreciation of Business Assets Defined
Business assets are often deducted on a business’s taxes in order to reduce the taxable income. These business expenses can include everything from printer paper to computers and servers. But with certain types of assets, it’s a better idea to depreciate the cost over multiple years. According to the IRS, those assets include machinery, equipment, buildings, vehicles and furniture.
To depreciate assets, you’ll use the Modified Accelerated Cost Recovery System (MACRS). Details on doing this are included in IRS Publication 946, and so are the tables you’ll use to determine the depreciation amounts for each year. This table gives you the property class and convention you’ll need to calculate depreciation.
Reasons for Asset Depreciation
You don’t just depreciate assets for tax purposes. It’s actually sound business accounting practice. As you pull data on your income and expenses each year, it’s important to get an accurate picture of your finances. If you have large purchases in one year and not in others, it can skew the numbers and make you seem more or less profitable than you are.
Depreciation also helps you more easily track how often you need to replace an asset. By replacing that computer after its five-year useful life, you’re able to maximize your tax deductions to keep your taxable business income in a reasonable range. Best of all, you’ll make sure you replace such assets often, rather than letting them deteriorate until they’re affecting productivity.
Types of Asset Depreciation
When it’s time to take a tax deduction for the asset, you’ll need to know how to calculate depreciation. There are two types of depreciation: straight-line depreciation and MACRS. Straight line is simpler and more straightforward, but MACRS lets businesses take the biggest deduction in the early years when the asset is new and, therefore, worth more.
Basically, under MACRS, you’re able to take a larger tax deduction in the early years, then gradually decrease it as the asset gets some age on it. With straight-line depreciation, you divide the cost of the asset over the useful period and take that amount each year. If you purchase a computer for $1,000, straight-line depreciation would have you dividing it over each of the five years of its IRS-defined useful life, giving you a $200 deduction each year.
Calculating Asset Depreciation Under MACRS
Calculating depreciation under MACRS requires a few extra steps, but as long as you have your documentation on hand before you start, you can easily tackle it. The easiest way to calculate depreciation is to use a MACRS Tax Depreciation Calculator, which you can easily find online. You simply input the information, and you’ll get the numbers you need for your bookkeeping and tax forms.
If you want to do things the manual way, though, follow these steps to calculate MACRS depreciation:
- 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. There are three options here: mid-month, mid-quarter and half-year.
- Using your depreciation method and property class, you’ll use the MACRS tables to find the percentage table you need to use for this year’s deduction.
Items That Can’t Be Depreciated
Small business owners might need a quick refresher on what can and can’t be depreciated for tax purposes, especially if you’re operating a business using personal equipment. Here are some restrictions to note if you’re calculating your tax deductions.
- The property can’t be held for personal purposes. If you use an asset for both personal and business use, you can only depreciate the portion of the asset used for business purposes.
- You must own the asset.
- The asset must be used in income-generating activities.
- There must be a determinable useful life.
- The asset must have an anticipated useful life of more than one year.
The IRS also has some exceptions to property that can be depreciated. Excepted property is detailed in Publication 946 and includes:
- Any property you 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 you used for capital improvements is also excepted. This equipment needs to be added to your overall capital improvement costs and depreciate it there.
Depreciation for High-Income Years
If you have a depreciable asset, there are times when a straight-line depreciation may be a better idea. A business that’s growing quickly and expects to have a higher income in the coming years could benefit from taking an even deduction every year. A higher-income means you’ll be in a higher tax bracket, so having more deductions will offset some of the taxes you’ll owe.
On the other hand, you may have an especially high-income year that encourages you to spend a little extra on your business. If you don’t expect the next few years to be as profitable, it could pay off to take what’s known as a Section 179 deduction. This allows you to take the full amount of the purchase as a deduction in the current tax year, up to a certain limit. Currently, that limit is $1,040,000.
In some tax years, the government incentivizes businesses to make purchases by offering a bonus depreciation for purchases made. This is often done to help stimulate the economy. In 2020, the bonus depreciation is 100 percent.
Limits on Vehicle Purchases
If you purchase a vehicle for business use – or you use your own personal vehicle for business purposes – you can depreciate the expense over multiple years, but there’s a limit. This changes from year to year.
For 2020, it’s as follows:
- $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
You don’t have to take the depreciation deduction on your vehicle, though. You can instead opt to claim mileage on the vehicle or claim the expenses related to operating the vehicle, including fuel, oil, repairs and insurance.
If you operate your vehicle for a combination of business and personal use, you’ll need to go with either the cost of operation or mileage. You can calculate it both ways and see which method brings you the biggest discount. If you want to go with the standard mileage method, though, you’ll need to rely on that method during the first year you use it for your business. Choosing the cost of operation will require you to stay with that for the remaining life of the vehicle.
Net Operating Losses for 2020
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.
First, net operating losses. 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. You can carry back those losses on your 2020 tax return.
The CARES Act also fixed a glitch that was introduced with 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, the latter of 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 certain business expenses to be capitalized rather than deducted. Although its definition makes it sound similar to depreciation, the IRS has you differentiate it for the purposes of your tax return. Capitalization often applies to startup costs and improvements you make to your business. They’re defined as investments you make in your business 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, which leaves your company as soon as the purchase is made, the money you’re investing is staying within the business as 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. In order to be deductible, the expense must be ordinary and necessary.
Ordinary: This means the purchase must be something that is commonly accepted as “ordinary” in the type of business you’re doing. It would include printing costs for menus for a restaurant, for example.
Necessary: This test asks if the expense helps your business in some way. However, it doesn’t have to be necessary for doing business to be applicable.
For businesses that sell products, it’s important to deduct the “cost of goods sold” each year. You’ll 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
Business owners can offset some of the taxes due on their annual earnings. 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.
- Investopedia: Depreciation
- IRS.gov: Topic No. 704 Depreciation
- IRS.gov: Publication 946 (2019), How To Depreciate Property
- Investopedia: Straight Line Basis
- Investopedia: Modified Accelerated Cost Recovery System (MACRS)
- Fast Capital 360: Calculating MACRS Depreciation
- IRS.gov: 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.gov: IRS Finalizes Regulations for 100 Percent Bonus Depreciation
- Journal of Accountancy: 2020 Depreciation Limits for Cars and Trucks Are Issued
- IRS.gov: Topic No. 510 Business Use of Car
- IRS.gov: 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
- Internal Revenue Service (IRS). "Topic No. 704 Depreciation." Accessed July 26, 2020.
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.