Depreciation and Business Taxes

Depreciation and Business Taxes - Buying Assets
Depreciation and Business Taxes - Buying Assets. Hero Images/Getty Images

Depreciation works better for businesses than it does for individuals. If you think of depreciation, you might think of driving your new car off the lot and having it depreciate - decrease in value. But depreciation is actually a helpful tax-saving measure for businesses. It's important to learn how depreciation works so you can take advantage of it. 

This article looks at the definition of depreciation and describes how depreciation is calculated.

It includes information on the latest laws affecting depreciation, so you as a business owner can understand how depreciation can work for your business taxes.

Updated Depreciation Benefits for Businesses

The PATH Act, enacted in late 2015, included some changes to depreciation calculations which benefit small businesses by increasing the ability of businesses to take more depreciation on purchases of business assets in the first year of ownership.

  • Bonus depreciation on purchases of new business assets is back, and will remain at 50% of the value of assets placed into service in the next few years.
  • Section 179 deductions for purchases of all types of assets have been permanently set at a maximum of $500,000 for future years.

These changes will allow businesses to plan for asset purchases, and Congress hopes this will encourage business capital purchases.

What Is Depreciation?

Depreciation is a non-cash expense that reduces the value of an asset over time.

When it's stated that depreciation is "non-cash," it means that depreciation is taken as an accounting entry and that the amount of cash held by the business is not affected.

Business assets that can be depreciated include equipment, machinery, technology and computers, office furniture, buildings and improvements to buildings, leasehold improvements to rented property, and business vehicles.

Land cannot be depreciated because it appreciates instead of depreciating.

Depreciation is taken on business assets to recognize the change in value of these assets as they age. Assets depreciate for two reasons:

  • Wear and tear. For example, an auto will decrease in value because of the mileage, wear on tires, and other factors related to the use of the vehicle.
  • Obsolescence. Assets also decrease in value as they are replaced by newer models. Last year's car model is less valuable because there is a newer model in the marketplace.

How Depreciation Is Calculated

Depreciation is calculated in various ways, but in general the process of calculating depreciation includes:

  • The original cost of the asset, including costs of acquiring the asset, transporting it and setting it up
  • Less the salvage value (the "scrap" value)
  • Divided over the years of useful life of the asset. The useful life of an asset is determined by the IRS based on a schedule set up for various types of assets. Check with your tax advisor for more information on "useful life" of different classifications of business assets.

Each year of the useful life of the asset, a specific amount can be included in the business's income tax return as an expense, thus reducing the business taxable income.

As an example, office furniture is purchased by a business for $20,000. The furniture has a useful life of 10 years and a scrap value of $1000. Using straight-line depreciation (described below), the $19,000 of the cost of the furniture is divided over the 10 years of life, so $1,900 can be deducted on the business's tax return for each of the 10 years.

Depreciation and Asset Purchase Method

It should be noted that depreciation on a business asset has nothing to do with the way the asset was purchased. Whether a business vehicle is purchased with cash or a loan doesn't affect the depreciation calculation. But, leasing an asset may affect the ability of the business to depreciate the asset. Read more about capital leases vs. operating leases, for more on this subject.

Methods of Depreciation

Depreciation is determined by one of several methods approved by the IRS.

The most common method is straight-line depreciation (described above), in which the same amount is expensed each year. Other methods are double-declining balance and sum-of-the-years'-digits.You might benefit from one of the other depreciation methods; talk to your tax professional and accountant about these.

Accelerated Depreciation

Depreciation can also be accelerated, allowing a business to deduct more of the cost of the business asset in earlier years. The two most common types of accelerated depreciation are Section 179 expenses and bonus depreciation.

For more information, see IRS Publication 946: How to Depreciate Property.