Depreciation Expense for Your Small Business: Tax Tips
One allowable deduction many small business owners have trouble understanding is depreciation expense, since it is a non-cash expense. Non-cash means that depreciation expense can reduce your net income — and your tax liability — but you do not actually write a check. It is recorded only on the books.
The concept of depreciation is based on the theory that assets — buildings, equipment, fixtures and vehicles — have a useful life. Once you make a purchase, you are allowed to deduct the cost over a period of time. However, the IRS has a provision that lets you deduct all the cost for certain items you buy during a tax year, up to a certain limit.
Standard Methods of Depreciation
The basic method of depreciation is straight-line. This means that you divide the cost (minus the estimated salvage value at end of useful life) by the years of life. Property life can range from five years (vehicles and office equipment) to twenty-five (buildings).
With the exception of twenty-five year property or property improvements, a 200 percent or 150 percent declining balance method can be used. This allows you to write off more in early years. These depreciation amounts are calculated by figuring straight-line then doubling, in the case of 200 percent, or multiplying by 1.5, for 150 percent. You still use the full period but the bulk of depreciation expense is taken in the first several years.
What can complicate calculations in the first year is when your ownership started. Rather than track exact dates, you can use a mid-month, mid-quarter, or mid-year convention. The popular mid-year convention means that for tax purposes, you owned the equipment for six months regardless of when you bought it. As a result, your depreciation is also based on six months in the first year. The IRS provides tables with percentages to help calculate depreciation expense in Publication 946.
As depreciation is recorded, the total amount accrued is reported on your balance sheet as an offset to asset values stated. For example, you might show equipment of $50,000 and accumulated depreciation of $30,000.
Section 179 Depreciation Deduction
The IRS also allows businesses to write off the entire cost of an asset purchase in the first year, with special rules for real estate. Any asset written off under Section 179 must be used more than 50 percent in a trade or business, and only the business percentage is written off. The maximum deduction in 2014 was $500,000 (this has dropped to $25,000 for 2015), with real estate having a cap of $250,000. You can write off numerous purchases as long as the total does not exceed the maximum. The deduction is also limited by the amount of taxable business income — if the deduction exceeds it, the remainder can be carried forward to unlimited future years. Form 4562 is used to elect the deduction.
If you use the Section 179 deduction as a rule, consider keeping a separate schedule with asset purchases and depreciation expense calculated a standard way. This allows you and others to see the age and value of the assets you own. There are many nuances and rules regarding depreciation expense and it is always wise to seek the assistance of an accountant or tax professional.