Heads up: this article has some information that’s only relevant to U.S. businesses.
Business purchases often come with high price tags attached, but many of them are investments that will be used in your company for years to come. Depreciation is a system that allows you to deduct the cost of a high ticket business item over the time you use it, rather than deducting the cost of the asset in a single hit.
In certain cases, it’s possible to leverage depreciation to reduce your tax bill. But calculating depreciation is a complex area that’s usually best left to the pros.
In this guide, we’ll explain how depreciation works, and give you an overview of how you could use it to increase your tax savings in the years when your business needs them the most.
The main function of depreciation is 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.
Depreciation employs two accounting principles: The Cost Principle and The Matching Principle. The Cost Principle requires that depreciation expenses be based on the original cost of the item, not the cost to replace the item or the current market value. The Matching Principle requires that the asset’s cost be allocated in a systematic manner to a specific, depreciable expense over the lifetime of the asset.
Applying depreciation to your business assets: book vs. tax depreciation
Businesses depreciate for both tax and accounting purposes – tax depreciation is set by law, while accounting depreciation tries to faithfully match the cost of an asset over its life. There are two common methods that are used to depreciate: the straight line method and the accelerated method. Let’s look at both of those:
This refers to the depreciation that is done for accounting purposes (on “the books”). The goal here is to match the cost of an asset with the revenue it earns across its lifetime. The most common way to depreciate assets for accounting purposes is the straight line method. 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 tax purposes, depreciation matches the tax cost to the amount of time that you use the asset. The accelerated depreciation method is more appealing for taxes because you get more of your money returned earlier in the asset’s life.
To depreciate an asset for tax purposes, you need to fulfill the following requirements:
- You need to own the property in question
- The asset must be used for your business
- The asset must have a useful lifetime of more than one year
While there are different methods for depreciation, you aren’t required to use just one method for books and taxes. You’re able to simultaneously use the accelerated method for taxes and the straight line method for accounting if you choose to. This is a benefit because it allows you to get a higher tax return earlier in the asset’s life, while maintaining the simplicity of the straight line method for accounting purposes. With that in mind, this is an area where your accountant can provide advice on which method is best for your business’ unique needs.
How does depreciation work?
During each accounting period, a portion of the cost of each depreciable asset is allocated, and that portion gets reported as a depreciation expense on your business’s income statement.
Buildings, machinery, computers, equipment, furniture, and vehicles are all examples of items that are depreciated. These items would be depreciated because they all have a relatively long useful life, compared to things like office supplies, for example, that have a short useful life (under one year).
The cost of items with a short useful life is deducted up front. Expensing these costs up front is more attractive because of the quicker tax benefit. But for those longer term investments with a higher price and long useful life, you’ll be required to depreciate the cost.
For example, if a company buys a piece of equipment for $1 million and expects the item to have a useful life of 10 years, it will be depreciated over the following 10 years. Every accounting year, the company will expense $100,000 (assuming they use straight line depreciation) against the revenues from the same accounting periods. For each depreciation year, the asset’s net book value will decrease by the amount that it was depreciated. In this example, after the first year, the asset will show a new value of $900,000 on the balance sheet.
Depreciation ends when the cost is fully recovered or when you take the item out of service (whichever happens first).
It’s always helpful to understand how depreciation can benefit your business. But if it isn’t your forte, just make sure you keep receipts and invoices for all of your business assets, and leave the depreciation calculations to your CPA.