Depreciation is a crucial income tax deduction for small business owners. Knowing how to use this tax deduction will save thousands. Every small business can use some form of depreciation deduction. This tax deduction is very profitable and worth taking some time to learn.
What is depreciation?
Small business owners reduce the value of an asset they own over time when they use depreciation on their taxes. This tax item, or asset, is then used as an expense on the tax form. When filing taxes, you use IRS form 4562.
The value of an asset decreases over time. Allowing a business to deduct this loss in value lowers the tax amount owed. An item is valued less the more it is used. This tax break allows for a business to take a loss over time.
The company uses the drop in value of an asset over a set period. Correspondingly, the IRS has some rules on what assets apply to this tax credit. Also, the IRS decides how many years the tax deduction can be used. Items such as computers, phones and copiers all lose worth over time.
By following IRS guidelines, a business can deduct the correct value of assets from its taxes. In turn, this allows businesses to spread out the cost of equipment and recoup money through tax deductions.
What kind of equipment can be depreciated?
The type of equipment eligible for depreciation costs will differ from company to company. Often, the big-ticket items fall under the depreciation rules. Some daily use items that you will need to buy every few years also qualify.
Common items depreciated fall into four main subcategories:
Three-year property
- Business Specific Equipment. (Example: A lawnmower for a landscaping business)
- Farm Machinery
- Tractors
- Tools or special machines
Five-year property
Seven-year property
- Office Furniture
- Appliances
- Items not in the other property categories
Real estate
- 27.5 years for residential rental properties
- 39 years for commercial properties
What are the advantages of using depreciation for a small business owner?
When a small business purchases an asset to use over several years using depreciation helps in four key ways:
Asset Valuation: The value of an asset declines over time. A business must adjust the value as the item is used. The longer an item is owned, the less value it holds.
Matching Expense: The depreciation expense allows a business to report the costs incurred due to the use of an asset. This approach helps when figuring out the total expenses and revenues for an accounting cycle.
Cost Recovery: The depreciation expense allows for a portion of the cost of the asset to be realized. This method spreads that cost out over time. Therefore, the tax deduction recovers the asset cost over time. The cost of an item is then lower when included.
Tax Deduction: The amount of revenue made by the small business adjusts with this tax credit. This practice allows for a lower taxable income and equals a tax savings for the small business.
How do you calculate depreciation on your taxes?
There are four methods of depreciation most commonly used. Straight-line, accelerated, units of production and sums of years digits are the four ways of calculating depreciation. The two methods that are used most often for small businesses are:
Straight-line Depreciation: In this method, the asset depreciates by the same amount each year. The constant rate is easiest to figure and used most often. This rate is one amount that is subtracted from the value each year.
Example: A piece of equipment costs $5,000 and will be deducted for five years. If the salvage value is $0, then a deduction of $1,000 each year would be taken.
Accelerated Depreciation: Sometimes referred to as the double declining balance method. In this method of depreciation, the asset depreciates more in the earlier years of the asset’s life.
Use this method when a business plans to update equipment often and would like to take advantage of as much depreciation as possible.
Example: A vehicle worth $20,000 when purchased. If the depreciation percentage is 25 percent, then the schedule would look like:
- $20,000 x .25 = $5,000 for year one
- $15,000 x .25 = $3,750 for year two
- $11,250 x .25 = $2,812.50 for year three
It is vital to take as many tax deductions as you can. Every small business wants to save money. Hence, the benefits of a depreciation tax credit. This credit is easy to use and open to any business.
The IRS offers several resources for small business owners trying to decide if an item is depreciable. Take time to figure the depreciation for each item accurately. You do not need to have an accountant for this tax deduction to be used for your business. A desire to save and a little time is all you need.
Keep track of your equipment when purchased. Save your receipts. Use spreadsheets to figure your deductions. You will see a big difference in your taxes when you start using the depreciation tax credit.
