Depreciation isn’t a nice word. It sounds like the opposite of “appreciate” which is weird because you’ll probably appreciate all the tax savings it will give you!
Even if you defer all things depreciation to your accountant, brush up on the basics and make sure you’re leveraging depreciation to the max.
What is depreciation?
Depreciation is the process of deducting the total cost of something expensive you bought for your business. But instead of doing it all in one tax year, you write off parts of it over time. When you depreciate assets, you can plan how much money is written off each year, giving you more control over your finances.
The number of years over which you depreciate something is determined by its useful life (e.g., a laptop is useful for about five years). For tax depreciation, different assets are sorted into different classes, and each class has its own useful life. If your business uses a different method of depreciation for your financial statements, you can decide on the asset’s useful life based on how long you expect to use the asset in your business.
For example, the IRS might require that a piece of computer equipment be depreciated for five years, but if you know it will be useless in three years, you can depreciate the equipment over a shorter time.
What is an asset?
An asset is anything with a dollar value. The IRS also refers to assets as “property.” It can be either tangible or intangible.
A tangible asset can be touched—think office building, delivery truck, or computer.
An intangible asset can’t be touched—but it can still be bought or sold. Examples include a patent, copyright, or other intellectual property.
Both tangible and intangible assets can be depreciated. In the case of intangible assets, the act of depreciation is called amortization.
What kind of assets can you depreciate?
The IRS sets guidelines for what types of assets you can depreciate. It needs to meet the following criteria:
- You own it
- You use it in your business, or to produce income
- You can determine its useful life
- You expect it to last more than one year
Some common examples of assets depreciated by small businesses include:
- Real estate
- Office furniture
What is a depreciation schedule?
A depreciation schedule is a table that shows you how much each of your assets will be depreciated over the years. It typically includes the following information:
- A description of the asset
- Date of purchase
- The total price you paid for the asset
- Expected useful life
- Depreciation method used
- Salvage value–how much you can sell it for once it’s past its useful life (e.g., how much a scrapyard would pay for your old work truck)
Types of depreciation
There are several ways to depreciate assets for your books or financial statements, but the IRS only allows one method of taking depreciation on your tax return. As a result, some small businesses use one method for their books and another for taxes, while others choose to keep things simple by using the tax method of depreciation for their books.
Let’s look at the options available for book and tax.
What it is: The most common (and simplest) way to depreciate a fixed asset is through the straight-line method. This splits the value evenly over the useful life of the asset.
Who it’s for: Small businesses with simple accounting systems, that may not have an accountant or tax advisor to handle their taxes for them.
Formula: (asset cost – salvage value) / useful life
How it works: You divide the cost of an asset, minus its salvage value, over its useful life. That determines how much depreciation you deduct each year.
Your party business buys a bouncy castle for $10,000. Its salvage value is $500, and the asset has a useful life of 10 years.
We plug those numbers into the equation:
Formula: (asset cost – salvage value) / useful life
(10,000 – 500) / 10 = $950
So, you’ll write off $950 from the bouncy castle’s value each year for 10 years.
Double-declining balance depreciation
What it is: The double-declining balance method is a slightly more complicated way to depreciate an asset. It lets you write off more of an asset’s value in the days immediately after you buy it and less later on.
Who it’s for: Businesses that want to recover more of an asset’s value upfront.
Formula: (2 x straight-line depreciation rate) x (book value at the beginning of the year)
How it works: For this approach, in the first year you depreciate an asset, you take double the amount you’d take under the straight-line method. In subsequent years, you’ll apply that rate of depreciation to the asset’s remaining book value rather than its original cost. Book value is the asset’s cost minus the amount you’ve already written off. The double-declining balance method doesn’t take salvage value into account.
We’ll use the bouncy castle example for straight-line depreciation above.
Since the asset is depreciated over 10 years, its straight-line depreciation rate is 10%.
In year one of the bouncy castle’s 10-year useful life, the equation looks like this:
Formula: (2 x straight-line depreciation rate) x book value at the beginning of the year
(2 x 0.10) x 10,000 = $2,000
You’ll write off $2,000 of the bouncy castle’s value in year one. Now, the book value of the bouncy castle is $8,000.
So, the equation for year two looks like:
(2 x 0.10) x 8,000 = $1,600
So, even though you wrote off $2,000 in the first year, by the second year, you’re only writing off $1,600. In the final year of depreciating the bouncy castle, you’ll write off just $268. To get a better sense of how this type of depreciation works, you can play around with this double-declining calculator.
What it is: Sum-of-the-year’s-digits (SYD) depreciation is another method that lets you depreciate more of an asset’s cost in the early years of its useful life and less in the later years.
Who it’s for: Businesses that want to recover more of an asset’s value upfront—but with a slightly more even distribution than the double-declining balance method allows.
Formula: (remaining lifespan / SYD) x (asset cost – salvage value)
How it works: To calculate SYD depreciation, you add up the digits in the asset’s useful life to come up with a fraction that will apply to each year of depreciation. For example, the SYD for an asset with a useful life of five years is 15: 1 + 2 + 3 + 4 + 5 = 15.
You divide the asset’s remaining lifespan by the SYD, then multiply the number by the cost to get your write off for the year. That sounds complicated, but in practice it’s pretty simple, as you’ll see from the example below.
Sticking with the bouncy castle example, it costs $10,000, has a salvage value of $500, and will depreciate over a 10-year useful life. For the castle’s 10-year useful life, adding up the digits would look like this: 1+2+3+4+5+6+7+8+9+10 = 55
The first year you depreciate using the SYD method, your equation will look like this:
Formula: (remaining lifespan / SYD) x (asset cost – salvage value)
(10 / 55) x (10,000 – 500) = $1,727
So, for your first year, you’ll write off $1,727.
Keep in mind, each year, the bouncy castle’s remaining lifespan is reduced by one, So, in your second year of depreciation, your equation will look like this:
(9/55) x (10,000 – 500) = $1,555
In your last year of depreciation, you’ll write off $173. Play around with this SYD calculator to get a better sense of how it works.
Units of production depreciation
What it is: The units of production method is a simple way to depreciate a piece of equipment based on how much work it does. “Unit of production” can refer to either something the equipment creates–like widgets–or to the hours it’s in service.
Who it’s for: Small businesses writing off equipment with a quantifiable, widely accepted output during its lifespan (e.g., based on the manufacturer’s specifications) who want to take more depreciation in years when they use the asset more and less depreciation when they use the asset less. Because this method requires tracking the use of the equipment, it’s generally only used for high-value equipment or machinery.
Formula: (asset cost – salvage value) / units produced in useful life
How it works: Using the formula above, you figure out the dollar value in depreciation for each unit produced. By adding up all the units produced in one year, you get the amount to write off. Once all of the units have been written off, depreciation of the asset is complete–its useful life is technically over, and you can’t write off any more units.
Since hours can count as units, let’s stick with the bouncy castle example.
Remember, the bouncy castle costs $10,000 and has a salvage value of $500, so its book value is $9,500.
Let’s say that, according to the manufacturer, the bouncy castle can be used a total of 100,000 hours before its useful life is over. To get the depreciation cost of each hour, we divide the book value over the units of production expected from the asset.
9,500 / 100,000 = 0.095
So that’s an hourly depreciation of $0.095.
In its first year of use, the bouncy castle is bounced upon for a total of 12,000 hours. So our equation would look like this:
12,000 x 0.095 = $1,140
We can write off $1,140 of depreciation for the first year.
That number will change each year. Remember, you can write off a total of $9,500, or 100,000 hours. Learn more about this method with the units of depreciation calculator.
Modified accelerated cost recovery system
What it is: The Modified Accelerated Cost Recovery System (MACRS) is the depreciation method generally required on a tax return. Under MACRS, assets are assigned to a specific asset class, and that class determines the asset’s useful life. You can find a detailed table of asset classes in IRS Publication 946, Appendix B.
A summary of the MACRS tables
|Asset Class||Useful Life (Years)||Types of Assets|
|3-year property||3||Tractors, qualified rent-to-own property|
|5-year property||5||Vehicles, computers, office equipment, research equipment, appliances for a rental property|
|7-year property||7||Office furniture and fixtures, farm equipment, any assets that don’t fit into other classes|
|10-year property||10||Boats, single-purpose farm structures|
|15-year property||15||Land improvement (landscaping, roads, and bridges)|
|20-year property||20||Multiple-purpose farm structures|
|Residential rental property||27.5||Any rental property where 80% of its rental income is from residential dwellings|
|Non-residential rental property||39||Office buildings, stores or warehouses that aren’t residential property, or which fit into other classes|
Who it’s for: Any business or rental property owner that claims depreciation expense on a U.S. federal income tax return.
How it works: Calculating MACRS depreciation is more complicated than calculating any of the book methods of depreciation. IRS Publication 946, Appendix A includes three different tables used to calculate a MACRS depreciation deduction. Rather than try to learn all the intricate details, it’s a good idea to let your tax software or accountant handle the calculations for you. You can also check out this MACRS depreciation calculator.
Comparing types of depreciation
To help you get a sense of the depreciation rates for each method, and how they compare, let’s use the bouncy castle and create a 10-year depreciation schedule.
As a reminder, it’s a $10,000 asset, with a $500 salvage value, the recovery period is 10 years, and you can expect to get 100,000 hours of use out of it.
For the sake of this example, the number of hours used each year under the units of production is randomized.
|Year||Straight line||Double-declining||SYD||Units of production||MACRS|
Depreciation journal entry example
If you want to record the first year of depreciation on the bouncy castle using the straight-line depreciation method, here’s how you’d record that as a journal entry.
Further reading: Journal Entries: A Simple Introduction
Depreciation expense vs. accumulated depreciation
Depreciation expense is the amount you deduct on your tax return. Since it’s an expense, you record it as a debit.
Accumulated depreciation is the total amount you’ve subtracted from the value of the asset. Accumulated depreciation is known as a “contra account” because it has a balance that is opposite of the normal balance for that account classification. The purchase price minus accumulated depreciation is your book value of the asset. Since it’s used to reduce the value of the asset, accumulated depreciation is a credit.
Further reading: Debits and Credits, A Visual Guide
Is depreciation a fixed cost?
Depreciation is a fixed cost using most of the depreciation methods, since the amount is set each year, regardless of whether the business’ activity levels change.
The exception is the units of production method. Under this method, the more units your business produces (or the more hours the asset is in use), the higher your depreciation expense will be. Thus, depreciation expense is a variable cost when using the units of production method.
How to depreciate rental property
If your business makes money from rental property, there are a few factors you need to take into account before depreciating its value.
Depreciate buildings, not land
You are allowed to depreciate the value of a building you’ve purchased–but the value of the land it’s on can’t be written off.
Often, the challenge is knowing how much you paid for each. If you can determine what you paid for the land versus what you paid for the building, you can simply depreciate the building portion of your purchase price.
If this information isn’t readily available, you can estimate the percentage that went toward the land versus the amount that went toward the building by looking at the taxable value.
For example, let’s say the assessed real estate tax value for your property is $100,000. The assessed value of the house is $75,000, and the value of the land is $25,000. So 75% of your property’s value is the house.
If you paid $120,000 for the property, then 75% of $120,000 is $90,000. That’s the depreciable value of the house.
When you buy property, many fees get lumped into the purchase price. You can expense some of these costs in the year you buy the property, while others have to be included in the value of property and depreciated.
The costs that can be deducted in the year of purchase include:
- Insurance premiums
- Prepaid mortgage interest expense
- Prorated real estate taxes
- Association dues
The costs that must be added to the value of your property and depreciated include:
- Legal fees
- Transfer taxes
- Title insurance
- Back taxes the seller owes, which you’ve agreed to pay
It’s a good idea to consult with your accountant before you decide which fees to lump in with the cost of your property.
Improving property before renting it
In between the time you take ownership of a rental property and the time you start renting it out, you may make upgrades. Some of them can be added to the depreciable value of the property. Those include features that add value to the property and are expected to last longer than a year. Examples include a new furnace, new windows, or new flooring.
On the other hand, expenses to maintain the property are only deductible while the property is being rented out – or actively being advertised for rent. This includes things like routine cleaning and maintenance expenses and repairs that keep the property in usable condition.
IRS Section 1250
Section 1250 is only relevant if you depreciate the value of a rental property using an accelerated method, and then sell the property at a profit.
Without Section 1250, strategic house-flippers could buy property, quickly write off a portion of it, and then sell it for a profit without giving the IRS their fair share. Section 1250 helps protect against this kind of tax avoidance.
So, if you use an accelerated depreciation method, then sell the property at a profit, the IRS makes an adjustment. They take the amount you’ve written off using the accelerated depreciation method, compare it to the straight-line method, and treat the difference as taxable income. In other words, it may increase your tax bill in the year of sale.
Bottom line, if you’re buying rental property and plan on selling it within a few years, you may want to talk to your accountant or tax advisor before making any big decisions.