Depreciation 101

What is Depreciation

The dictionary definition of depreciation is a decrease in value due to wear and tear over time. The accounting definition is the allocation of the cost of a tangible or physical asset over its useful life. The IRS defines it as the annual deduction that allows you to recover the cost of your business or investment property over time.

Depreciation vs. Amortization

You may also hear the term amortization. Amortization and depreciation both provide a method for:

• decreasing the value of an asset over time
• reporting the expense on the books of the company and the tax return

The key difference between the two is that depreciation expenses a fixed asset while amortization is used to expense an intangible asset. Intangible assets non-material items like trademarks, patents, franchise agreements, and copyrights.

When to Use It

You will start depreciating an asset when you first use it for your business. This may not actually be the date that you purchase the asset. Let’s say you purchased a new desk in June, but you didn’t move it into your office until August. Depreciation will start in August when it starts being used for business purposes. Once you stop using the asset for business or deduct all of the depreciation, then the depreciation for that particular asset stops.

Depreciation & Your Tax Bill

Depreciation is a reportable expense listed on your business’s balance sheet that increases the net worth of the company. The best part? Depreciation is a deductible expense. So, the more depreciation the company reports, the lower the taxable income, and the greater reduction in taxes owed to the IRS.

Generally, depreciation is reported using Form 4562 "Depreciation and Amortization". But there are a few circumstances in which Form 4562 is not required. See here for more information about when Form 4562 is needed.

What Is & Isn’t Depreciable

You can deduct tangible property such as buildings, machinery, vehicles, furniture, and equipment. And amortization can be deducted for intangible property such as patents, copyrights, and computer software.

In order to be eligible, the asset must:

• Be owned by the taxpayer
• Be used in a trade, business, or income-producing activity
• Have a useful life that extends beyond the year it is placed in service

Commonly depreciated business items include:

• Be owned by the taxpayer
• Be used in a trade, business, or income-producing activity
• Have a useful life that extends beyond the year it is placed in service

There are specific assets that are not eligible for depreciation. These include:

• Property that is placed in service and disposed of in the same year
• Equipment that is used to build improvements
• Section 197 intangibles (non-competes, copyright agreements, customer-based intangibles, designs, franchises, goodwill, etc.)
• Land
• Inventory
• Certain term interests

Getting Ready to Depreciate

You think you need to depreciate an asset, but how do you get started? What are the important considerations? Below are some quick tips and pointers to help explain and guide, but best is to touch base with a professional!

1. Was the cost of the asset less than $2,500? Rather than depreciate, you can directly expense the full cost as part of De Minimis Safe Harbor rules.
2.  If more than $2,500, you’ll need to know the basis of your asset to either do depreciation yourself or to provide to your professional helping. Basis is the cost of the asset, as well as costs associated with the asset, such as sales tax, installation charges, legal fees, and other acquisition costs.
3.  Along with basis, you also should track the date your put the asset into business service! This is usually the date purchased, but this is not always the case.
4.  After cost and service date, it is important to establish the ‘life’ of the asset (which is how many years predetermined by the IRS that an asset will last), the depreciation method, and convention to be used. It is suggested that you let professionals deal with this component, but if wanting to read more, information can be found in IRS Publication 946!
5.  We touched on De Minimis Safe Harbor above, but there are additional mechanisms that allow you to take more deductions up front! The most important of these are section 179 deductions. Certain assets qualify to be fully expensed in the year of service. There are also other special depreciation rules that can change the depreciation rate or allow for more upfront depreciation, meaning more business deductions and more immediate tax savings!

Conclusion

Reporting depreciation expenses on your company tax return can have a major impact on your overall tax bill. It increases the expenses you claim to offset taxable income. It also increases the overall value of your company. Knowing which purchases should be depreciated and how to report depreciation can be confusing. And on top of it all, determining which depreciation method to use and figuring out how to classify the asset to determine its recovery period further complicates things.