By Janet Berry-Johnson
You may be familiar with the term "depreciation" when referring to the declining value of a new car: The moment you buy a car and drive it off the lot, it depreciates by 10 percent, according to some estimates.
But depreciation in the tax world is different.
If you own rental property or run a business, it's important to understand depreciation and know how you can take advantage of this valuable tax-saving deduction.
In this article, we’ll cover:
All businesses incur some expenses to operate, create products or deliver services. As most business owners know, many of these expenses can be deducted in the year their company pays for them.
For example, a small-business owner may deduct the cost of reams of paper, toner cartridges, pens, paperclips, and other materials and supplies that help business get done every day.
For the most part, these supplies are used up in the year they're purchased. But what if the business owner buys a large piece of equipment? It wouldn't make sense to take a large deduction for the cost of the equipment in one year when that piece of equipment might be used over the next 10 or 15 years.
Depreciation allows business owners to allocate the cost of their assets such as real estate, vehicles, equipment, machinery and furniture to the years in which the assets are used. In other words, rather than take one big tax deduction in the year you purchase the property, you can continue to take a portion of the cost as a smaller deduction each year.
Depreciation can be calculated using a variety of methods. According to Michael Arveseth, CPA and CFO of Bailey's Moving & Storage, businesses often take advantage of tax incentives that allow for quicker depreciation.
For tax purposes, most property is depreciated using the Modified Accelerated Cost Recovery System (MACRS).
The type of property you have will fall under one of 9 IRS property classifications. The classification determines the number of years that the asset can be depreciated: 3, 5, 7, 10, 15, 20, 25, 27.5 or 39 years. Once you determine the asset class your property falls under, you can use the tables provided by the IRS to find the applicable depreciation rate that applies during each year of the asset's useful life.
For example, if a business purchases a $8,000 printer that falls into the five-year MACRS class, it can be depreciated as follows:
Sample depreciation schedule
|Year||Depreciation rate||Depreciation expense|
|1||20.00%||$1,600||($8,000 x 20.00%)|
|2||32.00%||$2,560||($8,000 x 32.00%)|
|3||19.20%||$1,536||($8,000 x 19.20%)|
|4||11.52%||$921.60||($8,000 x 11.52%)|
|5||11.52%||$921.60||($8,000 x 11.52%)|
|6||5.76%||$460.80||($8,000 x 5.76%)|
You'll notice that the printer depreciates over six years, even though it falls into the five-year asset class. That's because you don't get a full year of depreciation in the year you place the asset in service.
In some cases, you may be able to take advantage of greater tax incentives to depreciate assets more rapidly.
Arveseth explains: "Section 179 of the Internal Revenue Code allows for additional depreciation to be claimed in the first year that an asset is put into place." This section of the tax code allows businesses to deduct the partial or full purchase price of a qualifying asset in the year in which the property was placed in service.
There are some limits to what property qualifies for the Section 179 deduction. You also can’t deduct property that’s used 50 percent or less of the time for business in the year you place it in service.
The total amount written off under Section 179 cannot exceed $500,000 for 2016. If the total amount of equipment purchased during the year exceeds $2,010,000, your Section 179 deduction begins to phase out, dollar-for-dollar, for every dollar spent over $2,010,000.
The amount you can deduct under Section 179 is also limited by your business income. In other words, Section 179 deduction cannot reduce the business’ taxable income below zero. You can deduct enough Section 179 property to bring your taxable income to zero. Any excess can be carried forward to the next year.
To be depreciable, Steven Bankler, CPA and owner of Steven Bankler CPA Ltd., says assets must be "tangible property used in a 'trade or business' or 'held for the production of income' and placed into service during the tax year. If the property is inventory (held primarily for sale) or land, it's not eligible for depreciation."
Examples of assets that might be depreciable include machinery and equipment, office furniture, vehicles used for business travel, commercial real estate, and leasehold improvements.
The property also needs to be “placed into service” during the tax year in order to deduct depreciation. For example, if a company purchased a new printer on December 20th but the printer remained in its box and wasn’t used until the next year, the company could not deduct depreciation on the printer in the year it was purchased because it wasn’t “placed into service” that year.
Arveseth says depreciable property "is typically defined by having a [determinable] useful life greater than one year. Generally, this means that the property won’t wear wear out, decay, lose its value from natural causes or become obsolete – this may include things like furniture and printers, for example.
You can’t depreciate property that’s been placed into service and disposed of in the same year.
Intangible assets (such as patents or trademarks) amortize over time, similar to depreciation.
You can use Form 4562 to calculate and claim a deduction for depreciation and amortization. Attach Form 4562 to your tax return any year that you claim a Section 179 deduction, depreciation or amortization on assets placed in service during the year, or depreciation on a vehicle or other listed property.
To complete Form 4562, you'll need the following information:
- Description and cost of any assets being expensed under Section 179.
- Calculated depreciation and amortization expense for any assets placed in service during a prior year.
- Cost, how many years the asset can be depreciated, and method of depreciation for any assets placed in service during the year.
- Description. Date placed in service, cost and calculated amortization for any intangible assets placed in service during the year.
Arveseth recommends consulting with a qualified tax professional if you’re not comfortable calculating and applying depreciation.
If your business is audited by the IRS and your deduction is challenged, you may be required to pay additional tax plus interest and penalties.
About the Author: Janet Berry-Johnson is a CPA and a freelance writer with a background in accounting and insurance. Her writing has appeared in Forbes, Freshbooks, The Penny Hoarder, Discover Student Loans, Chase News & Stories, Capitalist Review, Guyvorce and Intuit's Firm of the Future blog. Janet lives in Arizona with her husband and son and their rescue dog, Dexter.
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