How to Calculate Small Business Depreciation

By Cameron McCool on October 9, 2018

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.

Depreciation defined

Depreciation is an accounting/tax principle that allows you to allocate the cost of a business asset over its useful life. In other words, depreciation means that the cost of an item is spread out over the number of years the item will be used by your business.

Does your business own any “depreciable” assets?

Depreciation only applies to certain assets. In the eyes of the IRS, an “asset” is any qualifying property (aka “thing”) your business acquires to help produce income.

To qualify as depreciable, the property needs to meet all of the following requirements:

  • It must be property your business owns

  • It must be used in your business or income-producing activity

  • It must have a “useful life” that you can calculate

  • It must be expected to last more than one year

For accounting and tax purposes, an asset must be placed in service (set up and used) in the first year that depreciation is calculated.

Not all assets are depreciated equally

The IRS has divided every type of business property into nine classes (when we say “everything” has been classified, we literally mean everything: from race horses to tugboats). Each class is named for its “useful lifetime.”

Because it’s unlikely that you need to depreciate the cost of a tugboat, here are the most relevant asset categories for small businesses.

  • Three-year property: tractors, some manufacturing tools, and certain livestock.

  • Five-year property: computers, office equipment, cars, light trucks, and assets used in construction.

  • Seven-year property: office furniture, appliances, and property that hasn’t been placed in another category.

You can also write off real estate over a longer time period.

  • 27.5 years: residential rental properties.

  • 39 years: commercial buildings.

Confusingly, land doesn’t qualify as “property”, and you can’t depreciate it (because it doesn’t “wear out”). That said, land improvements*,* such as roads, sidewalks or landscaping may be written off over periods of 10, 15, or 20 years, depending on the specific nature of the asset.

Dive into How to Depreciate Property to review a full list of depreciable assets.

Before you calculate depreciation, do this

You’ll need to gather the following info before you can calculate depreciation on any asset:

  • The useful life of the asset: this information is available in depreciation tables set by the IRS; the useful life is based on the type of asset in question. Unless you know your way around these tables, it’s best to have your accountant tell you the useful life of a specific asset.

  • The salvage value of the asset: this is the value of the asset at the end of its useful life. Just like the useful life of the asset, the salvage value is determined by a table.

  • The initial cost of the asset: the total cost of the asset includes all costs for acquiring the asset, like transportation, set-up, and training.

If you want to determine the “useful life” and “salvage value” of your assets, check out the list of asset classes in IRS publication 946. Your CPA can also find these values for you.

Once you’ve rounded up all of the above, you need to choose a depreciation method.

Accounting 101: Set Your Finances up the Right Way

Learn the fundamentals of small business accounting, and set your finances up for success with this free guide.

Figure out which depreciation method is best for your business

There are a bunch of methods you can use to to calculate depreciation. Sometimes you’re required to use a particular method, other times you can choose the method that gives you the best tax advantage.

For this reason—and at risk of sounding like a broken record—it’s best to let your CPA determine how to go about depreciating your business assets.

So that you’re familiar with the process, here’s a quick overview of two common methods and how each is used to calculate depreciation.

1. The Straight Line method

Straight Line depreciation = Total cost of the asset / useful life of the asset

With this method, you take the total cost of the asset and divide it by its expected useful life in your business. The result is the amount you depreciate each full year until you’ve reached the end of the useful life.

For example, say your business buys an asset with the following breakdown:

  • Purchase price: $1,000

  • Salvage value: $200

  • Depreciable value: $800

  • Useful life: 5 years

The annual depreciation you could deduct on the asset would be calculated like this: ($1,000-200)/5 = $160.

Heads up: this calculation changes if you don’t own the asset for a full tax year (e.g. if you purchase an asset in the middle of the year). In this instance, the annual depreciation expense is divided by the number of months in that year since the purchase.

Want to try this method yourself? Here’s a simple Straight Line Method Calculator.

2. Double Declining Balance

This method includes an “accelerator,” so that the asset depreciates more in the beginning of its useful life. You’ll commonly see this method used to depreciate vehicles; a new car depreciates more than an older one.

You can try this method yourself with a Double Declining Method calculator (just select the Double Declining method at the top of the calculator first).

Should you take advantage of Accelerated Depreciation?

In some cases, favorable tax plans can speed up the depreciation process, so you can get higher tax deductions faster. These include:

Both of these have unique limits and qualifications. Ask your CPA if any of your assets qualify, and have them determine if accelerated depreciation will give your business a tax advantage.

What happens when an asset reaches its useful life?

Once an asset has been fully depreciated, it’s considered to be “off the books” of your business. You can still keep using the asset if it’s useful. But you can’t deduct any more depreciation expenses on the item.

If the asset has a salvage value, that value will stay on your books until you sell it, or scrap it.

If you only remember two things about depreciation, you’re way ahead of the game

Don’t worry about calculating depreciation on every asset your business owns—especially if numbers aren’t your forte. Your time is better spent growing your business, working with clients, and managing your employees.

To get the most out of depreciation, just remember these two things:

  1. Depreciation can offer your business some awesome tax advantages

  2. If you own a depreciable business asset, or you’re intending to buy one, ask your CPA if there’s a way you can leverage depreciation to get the best tax savings in the long run.

With that knowledge in the back of your mind, you’ll be in a good position to maximize the tax benefits depreciation can provide.

Accounting 101: Set Your Finances up the Right Way

Learn the fundamentals of small business accounting, and set your finances up for success with this free guide.

This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.

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