What Is Depreciation?

Depreciation Explained

Cobbler repairing a boot heel using machinery
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As time passes, the value of any given asset decreases, and there needs to be a way for businesses to account for this loss in value. Depreciation is the process of allocating and claiming a tangible asset's cost each financial year that is spread over its predicted economic life. Small business owners can use depreciation to recoup some of the cost of an asset over its lifespan.

There are many different methods for calculating how much of an asset's cost can be written off. Find out more about depreciation, the most common methods for calculating it, and some common examples. Also learn which depreciation method is suitable for your business, and how to claim it on your taxes. 

Definition and Examples of Depreciation

Depreciation is the process of allocating the cost of an asset over its useful life. Depreciation is calculated by dividing an asset cost by how long it will be used or put into use, then subtracting one from that number. For these calculations, you need to know the asset’s cost, residual value, and estimated productive life.

The IRS clearly defines what counts as a depreciable asset: “Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property.”

Using depreciation calculation methods, a certain amount will be deducted from the asset's value each year. Expensive assets, such as manufacturing equipment, vehicles, and buildings, may become obsolete over time. Businesses must account for the depreciation of these assets by eventually writing them off their balance sheets.

Alternate name: Depreciable assets or property

A typical example is a vehicle used for business purposes. The depreciation rate for something such as a car will decrease every year because the car loses value with time and driving use. You can comp some of the cost of the initial purchase and maintenance of the vehicle by reporting it as a “depreciable asset” on your business taxes.

Vehicles, equipment, office furniture, computer hardware, and real estate are the most common depreciable assets for small business owners.

How Depreciation Works

Depreciation is the process of allotting and claiming a tangible asset's cost in a financial year spread over its predicted economic life. Accounting for depreciation is a process whereby a business owner can write off the cost of an asset over a certain period. It's an accounting technique that enables businesses to recover the cost of fixed assets by deducting them from their profits.

Specific rules apply to depreciation, however. For an asset to be considered depreciable by the IRS, the property must meet certain requirements. The asset must:

  • Be owned by you
  • Be used in your business or income-producing activity
  • Have a determinable useful life
  • Be expected to last longer than one year

Depreciation write-offs are one of the most popular deductions for small business tax filing. The depreciation write-off system requires that an asset, such as equipment, be placed into service before being depreciated on a company's balance sheet. The depreciation of an asset can be calculated using the following formula:

(Cost – Salvage Value) / Useful Life of the Asset

The salvage value is typically set at a percentage slightly less than the original cost, and may vary depending on the type and condition of the depreciable asset. Depreciation is used to reduce the amount of income that is subject to tax, but it can’t be deducted in the year the asset was purchased.

Types of Depreciation

Depreciation is a non-cash expense that can be deducted from taxable income. The IRS sets guidelines for how much depreciation can be taken on an asset, and these guidelines are based on the asset’s life expectancy.

Depreciation is an accounting method used to demonstrate the expense of using a business asset over a certain period.

There are two common ways to calculate depreciation of small business assets: straight-line and diminishing balance. Straight-line depreciation is when an equal amount of depreciation expense is deducted each year of an asset's life. Diminishing balance means the amount of depreciation expense increases in each year of the asset's life.

Straight-Line Depreciation

The simplest and most common method for calculating depreciation is “straight-line” depreciation. This type of depreciation is calculated by dividing the cost by the expected life, which gives you an equal expense each year. The formula for this method is as follows:

Depreciation = (Cost-Straight Line) / Useful Life

Diminishing Balance Depreciation

Diminishing, reducing, or “double-declining” depreciation is used for assets that have a faster expected rate of depreciation. The double-declining-balance method more accurately represents how quickly vehicles depreciate and can therefore be used to more closely match cost with the benefit from using the asset. This type of depreciation is calculated by dividing the cost by the expected life, which gives you an equal expense each year.

Depreciation = 2 x Straight-Line Depreciation Percent x Book Value at Start of Period

Not all assets or property can be depreciated on your business taxes. According to the IRS, the following items are exceptions to this particular tax deduction:

  • Assets used and disposed of in the same year.
  • Equipment used to build capital improvements. Capital improvements are typically made to enhance the property's overall value, prolong its useful life, or adapt it to new uses.
  • Section 197 intangibles—such as goodwill, existing workforce, business books and records, operating systems, patents, copyrights, licenses, or permits—must be amortized instead. Intangible properties can be depreciated if they meet specific requirements.

One of the most overlooked aspects of business is depreciation. It might not sound like a glamorous topic, and it's often forgotten about until tax time, but depreciation is an integral part of how a business accounts for expenses and income. The IRS allows taxpayers who own depreciable assets as defined by Section 1245 or 1250, such as machinery, furniture, and equipment, to take annual deductions for those assets on their income taxes.

Find the method that makes sense for your business’s assets (possibly with the assistance of an accountant) and make sure you are taking full advantage of this tax break.

Key Takeaways

  • Depreciation is the decrease in the value of an asset over time.
  • To calculate depreciation, you need to know an asset’s salvage value (how much it could be sold for) and its residual value (what it would be worth if it had no useful life left).
  • A business may take a tax deduction for the cost of its depreciable assets by claiming them on the operation’s tax return.