Depreciation is a deduction that enables a business to write off the cost of the property it buys. It does not apply to leased or rented property. Usually, annual allowances for depreciation are spread over the life of the property. As such, owners may forget to use these deductions after the acquisition year. However, now there are various options that enable the cost of certain properties to be deducted in full in the year it is purchased and used in a business. Keep reading for a quick refresher on asset depreciation for businesses.
What is asset depreciation?
Asset depreciation is the decrease in the value of an asset over time. From a tax perspective, whether the actual underlying value of an asset declines or increases, asset depreciation is a write-off over the life of the property (the period of which is fixed by the tax law). The reason behind spreading deductions for the cost of property is to enable a business to be in a position to replace the property at the end of its life.
How does depreciation benefit a business?
When a business buys property, such as a machine or a factory, it's making a capital investment, which is an asset carried on its balance sheet. Tax-wise, the cost of this investment is written off over time (called the useful life of the property, class life, or recovery period), providing tax relief to the business in more than one accounting period.
What is a depreciation expense?
A depreciation expense is an annual allowance that can be claimed as an income tax deduction. It is referred to as a non-cash expense because the business gets a deduction for the life of the property with no additional cash outlay beyond the initial cost of the property.
How asset depreciation works
Ensuring you receive the total tax deduction available to your business requires a fundamental understanding of how asset depreciation works, which is addressed in Section 179 of the Internal Revenue Service tax code. There are two types of Section 179 assets that can depreciate and be amortized: tangible assets (which you can see and touch) and intangible assets (which can't be seen or touched).
Tangible assets that can depreciate
- Equipment: Just about any type of equipment or machinery you can think of is a depreciable asset. From a small mobile device to a large cement mixer, business equipment can be depreciated over its applicable useful life (also referred to as its recovery period or depreciation period). This is typically five or seven years.
- Vehicles: All types of vehicles can be depreciated. Vehicles generally are classified as five-year property (i.e., a five-year depreciation period). But passenger cars, light trucks, and vans are subject to special rules (explained later).
- Real property: Land can't be depreciated because it's the type of asset that isn't used up over time. However, buildings are depreciable assets. Commercial realty, such as office buildings, factories, and silos, has a 39-year recovery period, while residential realty (rental real estate) has a 27.5-year recovery period.
- Fixtures: Items that are part of a building, such as lighting and communication equipment that are not given a different recovery period, are considered seven-year property.
Intangible assets to amortize
Intangibles that are purchased fall into two categories under the tax law:
Section 197 intangibles, which are purchased (not self-created) and amortized (meaning deducted ratably) over a period of no less than 15 years. Section 197 intangibles include:
- Goodwill and going-concern value, which is what the purchaser of a business pays over and above the value of the assets for the expectancy of continued customer patronage.
- Customer-based intangibles (e.g., customer lists).
- Supplier-based intangibles (e.g., price lists).
- Information-based intangibles (e.g., business books and records, operating systems, list of advertisers).
- Know-how intangibles (e.g., formulas, processes, designs).
- Licenses and permits.
- Trademarks and trade names.
Non-Section 197 intangibles, which are patents and copyrights that are instead depreciated using the straight-line method (which is the same as amortizing) over the lesser of the life granted to them by the government or the remaining life when they were acquired.
Section 179 asset deductions
When purchasing certain assets for business use, you typically have the option to deduct, from your income, a percentage of the asset's depreciated cost over several years. With a Section 179 asset deduction (also referred to as the first-year expense deduction), however, you may instead choose to deduct the asset's full cost in the year it's placed in use. The option you choose depends on your specific tax situation.
The IRS allows businesses to write off the entire cost of an eligible asset in the first year. 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 2019 is $1,020,000. For 2019, this annual limit is reduced dollar for dollar by each dollar of investment exceeding $2,550,000 in qualified property during the year. (These dollar amounts can be adjusted annually by the IRS for inflation.) 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, consider keeping a separate schedule with asset purchases and small-business asset depreciation expenses 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 the Section 179 deduction, and it's always wise to seek the assistance of an accountant or tax professional.
What is a Section 179 property?
To qualify as a Section 179 asset, the property must be:
- Considered eligible property,
- Acquired for business use, and
- Acquired by purchase.
Eligible property includes:
- Tangible personal property. These are items that can be measured, seen, and touched, such as machinery, office furniture, tools, and vehicles; single-purpose agricultural or horticultural structures; storage facilities (except buildings and structural components) used in distributing petroleum or any primary product of petroleum; and off-the-shelf computer software.
- Qualified improvement property. This is an improvement to the interior portion of a commercial building that has already been placed in service. However, it does not include elevators or escalators, enlargement of the building, or changes in the internal structure of the building.
- Certain improvements to commercial property. These are roofs; heating, ventilation, and air conditioning property; fire protection and alarm systems; and security systems.
Property can be new or used. Purchases financed in whole or in part can also qualify.
Special Section 179 limitations for vehicles
When it comes to passenger cars, light trucks, and vans, special limitations for the Section 179 deduction apply:
- The annual depreciation deduction cannot exceed dollar limits set annually by the IRS. For example, the dollar limit on a vehicle placed in service in 2019 is $18,100 (or $10,100 if bonus depreciation described below is not used or does not apply). So, as a practical matter, only a vehicle costing more than about $90,000 would trigger this dollar limit.
- The limit on heavy SUVs (those weighing more than 6,000 pounds but not more than 14,000 pounds) is $25,000 as adjusted for inflation. This means that an SUV placed in service in 2019 is subject to a $25,500 Section 179 limit.
There are no dollar limits on Section 179 allowances for certain vehicles, including:
- Non-personal use vehicles. Such a vehicle must be clearly marked with permanent advertising of the business, have a seat only for the driver or the driver and one other person, and contain either permanent shelving filling most of the cargo area or have a cargo area that's open, with the expectation that the vehicle (during both working and nonworking hours) never carries anything other than merchandise, material, or equipment used in the employer's trade, business, or function.
- Tractor-trailers and other specialty trucks.
- Heavy construction equipment.
- Vehicles that can seat more than nine passengers behind the driver's seat (e.g., shuttle vans).
Despite the term "bonus," this is not an additional deduction but rather another way to write off the cost of qualified property in full in the year of purchase. For 2019, the full cost, without any dollar limit, is 100 percent deductible, unless you opt out of bonus depreciation (the percentage starts to decline after 2023). Bonus depreciation applies automatically unless you opt not to use it. Making this election applies to all property within the same recovery period, so if you opt out for a vehicle (five-year property), you are also opting out for copiers, items used in research and experimentation, and other five-year property. Property qualifying for bonus depreciation is new or used:
- Tangible personal property, such as office furniture and heavy machinery.
- Film and television productions and live theatrical productions.
Bonus depreciation can be used in conjunction with the Section 179 deduction. For vehicles, the dollar limit on bonus depreciation is $8,000 for the year they are placed in service (through 2023).
As in the case of the Section 179 deduction, bonus depreciation applies whether the property is financed in whole or in part. However, property subject to floor plan financing (the type of financing used by car dealers) does not qualify for bonus depreciation.
Different methods of asset depreciation
There are different methods for calculating depreciation for small businesses. Some accelerate deductions so you write off more of the cost up front. Or you may be required or choose to use a method that spreads deductions for cost over the life of the property. Usually, accelerated depreciation is preferable because you get your tax breaks quickly. But startups that expect to have more income in the future may prefer to spread deductions, effectively saving deductions for later years.
The straight-line method 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 39 years for commercial buildings.
For realty, the actual deduction is figured by applying a percentage taken from an IRS table applicable to the property based on the month it's placed in service. For example, if you build a factory (39-year property) and begin to use it in May (the month it's placed in service), your deduction for the first year is 1.984 percent of what you're depreciating (the cost of the factory) and 3.175 percent for each year thereafter.
The double declining method of depreciation
For property other than long-lived property (e.g., commercial realty or nonresidential rental realty), you can accelerate depreciation deductions with a 200 percent or 150 percent declining balance method. 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. For example, with five-year property depreciated under the 200 percent declining balance method, you claim 20 percent in the first year and 32 percent in the second year, or over half of total depreciation in the first two years.
What can complicate calculations in the first year is when the property was placed in service. You must use a mid-month, mid-quarter, or mid-year convention, depending on the type of property and when you put it into use. The popular midyear convention means that for tax purposes, you are treated as having used the equipment for six months, regardless of when you bought it during the year. As a result, your depreciation is also based on six months in the first year. This means that five-year property results in depreciation over six years. The IRS provides tables in Publication 946 with percentages to help you calculate your annual depreciation allowance.
As small-business depreciation is claimed, the total amount accrued is reported on your balance sheet as an offset to asset values stated. For example, your balance sheet might show equipment of $50,000 and accumulated depreciation of $30,000.
The units of production method of depreciation
This method of depreciation is tied more closely to the property's usage or production capacity than the passage of time. In other words, depreciation is greater in a year in which there is a higher volume of activity. Depreciation under the units of production method is figured by dividing the cost of the property (minus salvage value expected to remain at the end of the property's life) by the expected number of units that the asset will produce over its life and then multiplied by the actual units during the current year.
This method could produce more favorable results for certain equipment, such as manufacturing machinery. But once the cost of the property has been recovered (i.e., fully depreciated), no additional write-offs are allowed.
Understanding depreciation systems
The basic depreciation system currently in use is the Modified Accelerated Cost Recovery System (MACRS). With this system in place, you select the most appropriate depreciation method and convention for calculating depreciation on an item. The most common of these is the General Depreciation System (GDS), which contains the recovery periods referenced above. However, you may be required by law to use the Alternative Depreciation System (ADS), which has different recovery periods.
Writing off items without depreciation
Do you have to depreciate an asset? No. Instead of depreciating the cost of certain property, you can opt to treat items as nonincidental materials and supplies (items for which you keep a record of consumption). Under an IRS-created de minimis rule, instead of using depreciation for small-business deductions, you can elect to deduct the cost of tangible personal property up to $2,500 per item ($500 prior to 2016) or invoice (there's a $5,000 limit for companies with audited financial statements). This option means the items are not treated as assets on your balance sheet; they are ordinary expenses. For example, say you buy 10 tablets costing $249 each for your sales staff. You can expense the cost, $2,490, provided you attach an election statement to your return.