Understanding the concept of depreciation is extremely important for business owners and investors. Depreciation is one of the most effective ways for a business to reduce taxable income, and therefore, its overall tax liability.
Correctly leveraging depreciation can have a huge impact on a business’s tax strategy, but without the right knowledge, this is a complex field to navigate. Different types of assets must be depreciated on different timelines. There are distinct methods of calculating depreciation expense based on the type of asset being depreciated. Depreciation rules at the federal level are not always the same as those on the state level.
These complexities, as well as others that we explore in this article, are important for leaders to bear in mind as they consider investing in new assets for their business. Understanding how to calculate depreciation, and knowing which types of assets are eligible to be depreciated, is central to effectively leveraging depreciation as part of a wider tax strategy.
At a high level, depreciation is an accounting method used to deduct the cost of an asset over the useful life of the asset.
Many items a business purchases are simple expenses that do not flow through to the business’s balance sheet. Others, particularly major assets, can be capitalized on the balance sheet as an asset and depreciated over time. In essence, this means the business can deduct the amount it paid for the equipment over time as the useful life of that asset expires.
There are many different types of assets, from the laptops your employees use to heavy manufacturing equipment. Generally, if an asset will last and be used for longer than a year, it is eligible for depreciation, however, there are many exceptions to these rules.
Different types of assets have different useful lives and must be depreciated in slightly different ways, depending on the required depreciation method and whether the asset is eligible for tax-accelerated depreciation.
Many major expenses that a business will incur are eligible for depreciation. Different types of assets must be depreciated on different schedules. Below are some of the most common depreciable lives:
Most assets fall into one of these categories, although it is worth noting that there are many industry-specific exceptions to these rules. Categories are outlined in the Modified Accelerated Cost Recovery System (MACRS), which is the most common method for tax purposes used to depreciate all tangible property placed in service in the United States.
To correctly calculate depreciation, it can be helpful to run through a series of questions. These can be used as a checklist to determine the correct schedule and method of calculating depreciation.
Depreciation is generally reserved for major purchases. Any purchases under $2,500 per item can be expensed under the de minimis safe harbor limit. This is calculated on a per-item basis, so even if a business purchased three computers for $6,000 total, these could still be expensed under these regulations since the cost per laptop falls under the limit.
It’s important to understand which depreciation method and life applies to your particular asset purchase. For example, a computer purchased for your employee can be depreciated over five years, but the desk they work at must be depreciated over seven years.
Additionally, depending on the type of asset purchased, it may be possible to accelerate the depreciation expense for tax purposes in the first year through bonus depreciation and Section 179. In 2023, bonus depreciation allows businesses to depreciate 80% of the value of an asset in the year it was purchased, although this will gradually phase out to 0% over the next few years. Section 179 offers immediate expensing on certain assets up to a certain cost limit and subject to income limitations.
States have their own rules when it comes to depreciation, and these can often result in a difference between depreciation expense at the federal and state level.
This difference has to be tracked over the useful life of each asset that is being depreciated. Businesses may have to make adjustments to their state taxable income, as this may differ from federal taxable income.
There are different ways to calculate depreciation. These are typically dictated by the type of asset being depreciated.
In general, assets with a shorter useful life are depreciated using the double declining balance method, an accelerated depreciation method that depreciates assets twice as fast as the straight line method.
Assets with a longer useful life, including residential and commercial real estate, are typically depreciated using the straight line method, which depreciates the asset equally over its useful lifetime.
Depreciation is a complex field. Without the right advice, it’s easy for businesses to make errors in calculating depreciation that could see them either underpaying or overpaying taxes.
One of the biggest mistakes businesses make is failing to depreciate any of their purchases. Instead, some poorly-advised businesses simply expense all of their purchases, ignoring depreciation altogether. Businesses may also misidentify the depreciable life or method that should be used for an asset, which could lead to a 15-year asset being depreciated over 5 years.
Businesses often fail to account for the impact of repair regulations, which specify that certain capital expenditures are considered repairs and maintenance expenses and are not subject to depreciation. For example, if a business makes repairs that do not improve or enlarge an asset, but simply maintain its normal use and function, these would generally be considered repairs, even if they amount to more than $2,500.
Failing to correctly account for depreciation can have significant consequences. If a business used an impermissible calculation method or made an error in its calculations, the IRS can challenge this. In the event of an IRS examination, businesses may be required to furnish their depreciation calculations and recalculate where necessary. Outside the context of an IRS examination, any change to depreciation methodology and calculations is generally considered a Change of Accounting Method which requires further compliance and reporting to the IRS.
It’s important for businesses to work with experienced tax advisors to correctly determine and calculate depreciation. This is a highly nuanced area of tax strategy, with all kinds of intricacies, exemptions, exceptions, and complexities that are challenging for business owners to stay on top of.
For businesses with significant capital expenditures, depreciation is an extremely valuable component of a wider tax strategy. Correctly leveraging depreciation and understanding exactly what qualifies demands the support of experienced tax professionals with a track record of helping businesses navigate their depreciation schedules.
At Smith + Howard, our tax team serves thousands of clients around the country and has significant experience guiding businesses through the process of calculating and implementing depreciation schedules. Our advisors take a consultative approach focused on building proactive tax strategies that optimize the long-term financial performance of your business.
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