As a small business owner, it’s important to take advantage of every tax deduction available. Deductions help offset profits and lower your taxable income. Tax depreciation is a deduction you can claim on your income tax return each year if you meet specific requirements set by the Internal Revenue Service (IRS).
Claiming depreciable assets can save small businesses thousands of dollars in taxes. Check out our guide below to learn more about tax depreciation.
What Is Tax Depreciation?
Tax depreciation is an annual income tax deduction that allows business owners to recover the investment costs of assets. Depreciation is the decreasing value of a business asset due to wear and tear, deterioration, or age. Depreciable assets are property that helps your business generate revenue, and they can be claimed when you file your federal income taxes for the prior year.
Tax depreciation is claimed as an expense so that it can be deducted from a business’s taxable income. For example, a small business clears $200,000 in net income for the year. It claims a $50,000 depreciation deduction for the building and equipment owned and used for the business. The business’s taxable income decreases from $200,000 to $150,000.
According to the U.S. Small Business Administration (SBA), the average small business is assessed a 19.8% tax rate on their income. At this rate, this small business would save $9,900 by claiming $50,000 in tax depreciation. The more deductions you claim, the less you have to pay in taxes. Tax depreciation is a simple way to hold onto more of your profits.
Once an asset is in use, its cost is depreciated over time. This means that you don’t claim the total amount of the expense upfront in one lump sum. You depreciate the asset each year by claiming a portion of the cost on your income tax return. This method is followed until you’ve eventually claimed the entire cost of the asset or until it’s no longer in use.
What Is a Tax Depreciation Schedule?
A tax depreciation schedule is a table that shows the amount of depreciation to claim for each of your business assets. It’s usually a document your accountant refers to when filing your taxes. A tax depreciation schedule also shows the life span of each asset.
For example, say you buy a piece of equipment that costs $100,000, and you expect it to be useful for 10 years. Your tax depreciation schedule would tell you to deduct $10,000 each year for 10 years to recover the total cost of the equipment within its life span.
IRS Publication 946 explains how to depreciate property in greater detail. It provides many tax tables that show how to recover costs for different types of assets in various industries. Certain depreciable assets have a specific period in which they can qualify as an income tax deduction, for example:
- Tractors and manufacturing tools can be claimed for up to three years.
- Computers, office equipment, vehicles, and appliances can be claimed for up to five years.
- Office furniture and fixtures can be claimed for up to seven years.
- Residential property can be claimed for over 27.5 years.
- Commercial buildings and nonresidential property can be claimed for up to 39 years.
As you can see, the time you have to depreciate assets varies greatly, so each business’s tax depreciation schedule is unique. If assets have been in use for less than a year when it’s time to file your taxes, you can claim deductions for the months in which they were used. Also, if any deduction is greater than the business’s income that year, the IRS allows you to carry the balance of this value over to future tax years.
According to the IRS, depreciable assets are tangible and intangible property. Intangible property refers to assets such as computer software, copyrights, and patents. Tangible property that’s deductible includes assets such as:
Inventory and land are both considered tangible property but don’t qualify as depreciable assets. Land improvements can sometimes be claimed as a depreciable asset, depending on the situation. Leased property doesn’t qualify either, although an exception can be made if you bear the full burden of the capital investment in the property.
The IRS has also set the following requirements to claim tangible and intangible property costs:
- You must own the property. Even if the property is subject to debt, you’re considered its owner. Leased properties, life tenants, and cooperative apartments may be deducted if they meet the requirements in IRS Publication 946.
- The property must be used in your business. It can also be claimed for any income-producing activity. Any property used for personal activities can’t be deducted; however, if you use an asset for both business and personal reasons, you can still deduct the portion used for business.
- The property must have a determinable useful life. According to the IRS, this means that it’s "something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes." You must be able to determine the life span of the asset.
- The property must be expected to last more than one year. The asset should have a life expectancy that’s much longer than one year so that the depreciation deduction can be made over a period of time, usually over multiple years.
To claim depreciable assets, you or your certified public accountant (CPA) will need to fill out and attach a Depreciation and Amortization Form 4562 to your income tax return.
How to Calculate Depreciation
It’s important to correctly calculate depreciation for tax purposes to receive the greatest tax benefit. If depreciation is incorrectly calculated, it could end up costing you thousands of dollars. There are three ways to figure out how much of a deduction you can claim for your depreciable assets.
First, you’ll need to know the initial cost of each asset. To calculate the initial cost, take the following into account:
- The original purchase price of the asset
- Sales tax paid at the time of purchase
- Shipping and delivery costs
- Any installation charges
- Other costs incurred before you could use the asset
You’ll also have to determine how many years you’re able to depreciate an asset. The IRS sets depreciation rules. After you have these two numbers, you’re ready to use one of the following methods to calculate depreciation.
The straight-line method is used to depreciate an asset an equal amount each year over its useful life span. It’s the most used and straightforward depreciation method. When you use the straight-line method, the value of an asset is reduced to its salvage value — the price you could get if you sold the asset at the end of its useful life.
To calculate the amount to depreciate each year, subtract the salvage value from the initial cost of the asset. Divide the result by the estimated useful life of the asset in years to get the annual depreciation expense. Let’s look at an example.
Say you purchase a piece of equipment for $5,000 for your business. It has a salvage value of $500 after a five-year life span. Subtract $500 from $5,000 and divide the result of $4,500 by five years. This method shows that you can claim a $900 depreciation deduction per year for five years to recover the cost of the equipment.
Here are a few advantages and disadvantages to the straight-line method:
Pros: Easy to understand and calculate
Simple to apply to a tax depreciation schedule
Suitable for less-expensive assets
Useful for assets that act consistently over their life spans
Cons: Doesn’t account for the loss of efficiency/repair expenses
Fewer upfront benefits than the accelerated method
Not always suitable for costly assets
Not useful when the life span of an asset is unpredictable
The IRS recommends using the straight-line method if you can depreciate a patent or copyright. The useful life of this type of asset is the time the government assigns to it or the time remaining when you acquired the patent or copyright. They also recommend using this method to depreciate the cost of computer software for over 36 months.
Accelerated Method (MACRS)
The accelerated method of calculating depreciation is used to quickly recoup an asset’s cost in the first years of its useful life. It’s also known as the Modified Accelerated Cost Recovery System (MACRS). Businesses use this method to depreciate an asset more at the beginning of an asset’s life and less in later years.
To calculate depreciation using MACRS, first determine an asset’s initial cost and class. The IRS determines which assets are eligible for MACRS and divides the assets into classes. Each class is given a specific number of years for its life span, during which you can claim depreciation deductions. Refer to the MACRS Depreciation Methods Table in IRS Publication 946 to find an asset’s class.
When using MACRS, you must also determine the depreciation:
- Method: Depending on the asset’s class, you’ll use one of three depreciation methods: the 200% declining balance method using the General Depreciation System (GDS), the 150% declining balance method using GDS, or the straight-line depreciation method using the Alternative Depreciation System (ADS). The MACRS depreciation table will help you decide which method to use.
- Convention: There are three MACRS depreciation conventions. Choose a mid-month, mid-quarter, or half-year convention, depending on when you first began using the asset. The mid-month convention is only applicable for residential rental property, nonresidential real property, and any railroad grading or tunnel bore.
- Percentage: Refer to the MACRS Percentage Table Guide in Appendix A of Publication 946 to find the percentage of your asset’s value that you can claim as a deduction each year. This IRS publication also includes a MACRS worksheet you can use with the percentage table guide to calculate your depreciation deduction.
Alternatively, you can use an online MACRS tax depreciation calculator. Just plug in the required information, and it calculates the annual depreciation amount for you. Consider the following advantages and disadvantages of using the accelerated method to calculate depreciation.
Pros: Good option for years with high profits
IRS provides helpful MACRS tables and charts
Larger tax deduction benefits in earlier years
Cons: Bad option during less productive years
More complex calculation method
Smaller tax deduction benefits in later years
Only for business assets purchased after 1986
Tax rules governing MACRS are quite complex, so it’s best to consult a tax professional if you decide to use this method.
Section 179 Deduction
A section 179 deduction is an alternative to depreciation deductions. You can use this method to recover all or part of the cost of qualifying assets for the year it was first used. It’s easy to calculate a section 179 deduction for business property. Calculate the property’s initial cost and claim this amount as an allowable expense.
The complicated part is determining if the property qualifies for this deduction. According to the IRS, the asset must be one of the following kinds of depreciable property to qualify.
- Tangible personal property
- Other tangible property, excluding buildings and structural components, used as:
- An integral part of manufacturing, production, or extraction, or furnishing transportation, communications, electricity, gas, water, or sewage disposal services
- A research facility used in connection with any of the above activities
- A facility used in connection with any of the above activities
- A facility used for the bulk storage of fungible commodities
- Single-purpose agricultural (livestock) or horticultural structures
- Storage facilities, excluding buildings and their structural components, used in connection with distributing petroleum or any primary product of petroleum
- Off-the-shelf computer software
- Qualified section 179 real property improvements, such as roofs, heating, ventilation, and air conditioning property, fire protection and alarm systems, and security systems
You also need to know that there’s a limit for how much you can recover per property in a single tax year. The IRS sets this limit and adjusts it periodically for inflation. Be sure to check the current year limit when claiming a section 179 expense deduction. Here’s a quick look at some of this method’s pros and cons:
Pros: Can make large asset deductions
Recover investment more quickly
Greatly reduce taxable income
Cons: Can’t use the deduction if your costs exceed the current limit
Limits on expense claims for sports utility vehicles
Complicated rules about qualifying properties and deduction limits
The section 179 deduction option allows small businesses to make bigger investments in assets that they need to run a competitive and profitable business. To completely understand all the rules governing this type of deduction, consult with a tax professional when filing your business taxes.
What Is Bonus Depreciation?
Some tangible personal properties qualify for additional first-year depreciation, known as bonus depreciation. It allows taxpayers to deduct 30%, 50%, or 100% of depreciation in the year the asset is first used or acquired. To qualify as eligible property, the original property must begin with the taxpayer. It must also be one of the following:
- A MACRS property with a recovery period of 20 years or less
- Depreciable computer software
- Water utility property
- Qualified leasehold improvement property
Other acquisition requirements and usage dates must also be met as set forth by the IRS.
Learn More About Business Software and Taxes Today
Deductions, also known as write-offs, are essential to use when running a small business. Depreciation deductions help taxpayers lower how much they owe in taxes to the United States government. Federal tax laws within the Internal Revenue Code can be difficult to understand. When it’s time to file your taxes, seek professional tax advice from qualified accountants.
In addition to providing resources on various tax topics, Skynova offers business software designed to help small businesses succeed. From our free invoice template to our accounting services, Skynova makes it easier to track business expenses, income, sales tax, and so much more. Check out our additional tax resource pages and business templates to learn more today.