A Basic Guide to Depreciation for Small Businesses
As a small business owner, you can deduct depreciation that your assets experience over time. Here’s what to know about depreciation and how to calculate it.
- Depreciation is the loss of value an asset experiences over time
- Small businesses can deduct depreciation from assets like cars, property, and equipment
- There are three methods to calculate depreciation: straight-line, accelerated, and Section 179, all with pros and cons
- Discuss your options with a tax expert at Provident CPA and Business Advisors
You have many concerns when you’re doing your taxes as a small business owner. You have to gather your expenses and records, report income properly, and ensure that you’re taking all the right credits and deductions. This is all on top of paying quarterly estimated taxes and managing your finances.
Tracking depreciation is one way to significantly reduce a tax burden each year. It may sound like a confusing concept initially, but once you understand the essentials, it’s pretty straightforward.
Here is a basic guide to depreciation as a small business owner:
What is depreciation?
When you purchase an asset, the value of that asset decreases over time. The amount of value lost is known as depreciation.
This is important for business owners because you can write off depreciation on your annual tax return as a deduction, lowering taxable income and thus the amount you’re taxed. Even though an asset depreciates, it is not necessarily a negative, since it helps you save on taxes.
One of the most common uses of the term depreciation occurs in the auto world. When you purchase a new car, it loses value as soon as you drive it off the lot, aka depreciates. It is immediately considered a used car.
Depreciating assets that you may use in your business include expensive equipment or machinery, real estate, technology like computers, automobiles, and more. Some intangible assets can depreciate as well, including intellectual property. And in that case, the process is known as amortization.
Understanding and calculating depreciation
The next component to understand is how to actually calculate depreciation, which can be tricky when recording your deductions.
First, a few rules:
- Your asset must have been in use for more than one year.
- You need to write off depreciation for the asset’s useful life.
- Depreciation starts once it is being used and stops when the cost has been recovered or you stop using it for your business.
- You must be the owner of the property or asset.
You also need to know how long you can write off the depreciation:
- Assets like office equipment, electronics, automobiles, and appliances have up to five years to be deducted.
- Furniture and fixtures have seven years.
- Rental properties have 27.5 years for residential and 39 years for commercial or non-residential.
Next is how to get started with calculations. You have three methods for writing off the depreciation: straight-line, accelerated, and Section 179 methods.
- Straight-line method: In this technique, you deduct the same amount of depreciation each year on a given asset over its useful life. To find this amount, subtract the amount you could sell it for at the end of its useful life (the salvage value) from the asset’s cost, and then divide that number by the number of years it will be in use.
- Accelerated method: This one allows you to take bigger deductions early on and smaller deductions later. Many small business owners decide to use this method, and it takes less math on your part. You will use the percentages in IRS Publication 946, Appendix A, and the Modified Accelerated Cost Recovery System (MACRS) created by the IRS. This approach is beneficial for businesses in need of cash because it allows them to deduct more during the first few years after buying an asset.
- Section 179 Deductions: Section 179 deductions allow you to deduct the full cost of an asset the year you acquire it for business. The maximum deduction is $1,050,000, and the value of property purchased limit is $2,620,000 for 2021. This option provides a more immediate, huge tax break. The government started offering this option after the Tax Cuts and Jobs Act was passed in December 2017, as an incentive for small business owners to make purchases to grow their businesses. This deduction can be used for computers, business machinery, cars, and office equipment.
Various software options can help calculate depreciation and save asset information from year to year. But it’s always wise to talk to a tax professional about your options so you can land on the right method. Otherwise, you could be leaving money on the table that your small business needs now.
Working with a small business financial expert
Depreciation of business assets is not always easy to understand. But you always must be thorough when completing your tax return and deducting expenses. You never want to do something suspect that will attract the attention of the IRS.
Talk to a tax professional who will help you understand tax laws and best practices you should follow. Always make sure you’re taking advantage of all tax breaks available—and remember that sometimes these change from year to year.
The team at Provident CPA and Business Advisors is here to help. We assist in putting the right financial plans in place to grow small businesses and help them pay the least amount of tax legally possible. We make sure you don’t miss anything when preparing your taxes, including credits and deductions.
Contact us today to get started with an experienced tax professional.