As a business owner, you may be aware that asset depreciation can help you save money on taxes, but if you’re new to the idea, it can seem overwhelming. Fortunately, asset depreciation is simpler than most people think—and even if you only have a high-level understanding of how it works, you can use it to your advantage when buying new equipment or other assets for your business.
The Basics of Depreciation
Let’s start by going over the basics. In relation to business ownership, depreciation refers to an income tax deduction that helps you compensate for the costs and losses associated with assets necessary to run your business effectively. Through depreciation, you’ll calculate how much value the asset has lost over time, and you can use the difference as a deduction to reduce the taxes you’ll owe.
Depreciation is also important for your internal bookkeeping, giving you the ability to keep track of how your assets are valued over time. You may be forced to use different calculations for these purposes; for example, you may deduct a different asset value for tax purposes than what accurately reflects the asset’s loss in value.
The Requirements of Depreciable Assets
So what assets “count” as depreciable? Part of that depends on your region. Australia has different incentives and requirements for depreciable assets than the United States. However, there are some commonalities you can count on all over the world.
First, the asset must be a “fixed” asset—that is, something that can’t be immediately turned into cash. If you buy a car for your business, or a commercial vehicle like a bus or a truck,depreciation is just one of the tax incentives available to you. You may also be able to depreciate office equipment, like computers, monitors, appliances, and even furniture. You can depreciate home office space—a section of your home that’s used exclusively for business purposes—and full buildings, like offices, factories, or warehouses. You can also depreciate major repairs (like replacing the roof of your business), and even some intangible assets, like computer software or patents.
However, you can’t depreciate inventory or land, nor can you depreciate leased or rented property. One of the requirements is that you actually own the asset (or that your business owns it). You’re considered the owner of the asset so long as you paid cash for it or took out a loan or mortgage to claim the property—so if you bought a company car with a loan, you’re still considered the owner.
Of course, the asset must also be used in your business. You cannot deduct your personal vehicle, nor can you deduct repairs to your home. The asset in question must also have what’s known as a “determinable, useful life.” In other words, the asset must deteriorate or become less useful over time, in a measurable way. For example, it’s well-known that vehicles become less reliable as they age and become more heavily driven; over time, they lose value and eventually will be practically useless. That “useful life” must be more than one year as well; there are no deductions for short-term assets that will stop being valuable within a year.
Multiple Depreciation Methods
Depending on your goals, there are multiple ways you can depreciate your assets:
- Section 179. Section 179 is a method of tax reporting that allows you to deduct up to $500,000 in depreciation expenses for any fixed assets. It’s the most straightforward and potentially most useful way to calculate depreciation for taxes if you’re looking to deduct depreciation in the same year you buy the asset.
- MARCS stands for the Modified Accelerated Cost Recovery System, and is used for income tax purposes. If you use this instead of other methods, you can write off a big chunk of your asset’s depreciation in the early years of your asset’s useful life, then write off additional depreciation later.
- Straight Line.Straight line depreciation is the most consistent form of calculating depreciation, since you’ll write off a consistent value each year over the course of the asset’s useful life.
- Book-based calculations. If you’re only keeping track of depreciation for bookkeeping purposes, there are also a number of other calculations you might consider. For example, you might you use sum of the years digits (SYD), double declining balance (DDB), or units of production (UOP). Different industries will prefer different methods here.
Recording and Reporting
Though you won’t be claiming a tax deduction based on your depreciation calculations until the end of the year, it’s a good idea to record your assets’ depreciation on a monthly basis. That way, you can get an accurate picture of your profits and losses throughout the year, and you’ll have a paper trail that shows exactly how your assets have changed over time. Most modern accounting software will have a feature to help you calculate depreciation, so you can handle it quickly and relatively stress-free.