All About Depreciation
Depreciation is the accounting way of measuring the wear and tear on your fixed assets. Although it has no impact on cash, it is part of your expenses. That means it lowers your company's net income, which means lower taxes. When you buy assets, you don't get to deduct them right away, even though they have taken up a portion of your cash or increased your liabilities. Taking depreciation expense allows you to deduct that asset over time, as you use it to help produce revenues.
Although there are several different ways to depreciate assets, the two most used by small businesses are the straight-line and tax (or MACRS) methods. Both are acceptable for use on your business tax return. You can use one method for book purposes and another for tax purposes (though you have to report that fact to the IRS), but it's easier to keep your books and tax records the same way. MACRS, or modified accelerated cost recovery system, lets you take bigger depreciation deductions sooner than does straight-line (that's where the “accelerated” comes from); overall, though, the total depreciation over the life of the asset will be the same.
Whichever method you choose, you'll need some basic pieces of information to get started: the asset cost, purchase date, useful life, and what percentage is used exclusively for the business. If the asset won't be used 100 percent by the business, you can depreciate only the portion used by the company. For example, if you have a laptop that you use both for business and personal reasons, you must estimate the percentage of business use; if the business use is 80 percent, you can only deduct 80 percent of that year's total depreciation calculation for the business.
You can choose to depreciate all or part of your newly acquired assets for tax purposes, under a rule called the Section 179 deduction. Instead of depreciating them over time, you can book an expense for the total fixed assets purchased during the year. Two catches: the deduction can't cause an overall loss, and it can't be more than the IRS limit for that tax year.
MACRS is what the IRS wants businesses to use for calculating depreciation. Under this method, all assets are lumped into categories, and each category comes with a specific depreciation schedule. For example, all office furniture is considered seven-year property, while all computers are considered five-year property; each property class comes with its own preset annual expense percentages. You can download a complete copy of the table from the IRS website.
In most cases, you'll use the “half-year convention” table. The basic point of this table is that no business buys all its assets on January 1. The half-year convention assumes that all new assets were purchased at mid-year and gives them all 50 percent of the full depreciation for the first year; it then allows for the full-year expense going forward. You'll notice that the tables have an extra year built in; three-year assets have four years of percentages, five-year assets have six years of percentages, and so on. That's to account for the half year at the end of the asset's life, to make up for the missing half year at the beginning.
Here's how MACRS depreciation works. First, figure out which category your asset belongs in, according to the IRS chart. Then you look up the percentage for this year in the asset's life. For instance, if it's the second tax year you have the asset, use the percentage for year two. Finally, multiply the total original asset cost by the percentage from the chart. If the asset isn't used exclusively for business, you have to take an extra step and multiply the business-use percentage by the depreciation amount you just calculated.
Straight-line depreciation is usually an acceptable option for most assets, even though the IRS typically prefers MACRS. Although this method gives you a lower depreciation expense up front, the annual deduction remains steady over the life of the asset and gives you bigger deductions than MACRS in later years.
When it's allowed, a lot of new business owners prefer to use straight-line depreciation for assets purchased in the early years. That's because new businesses often sustain losses early on, and bigger depreciation deductions aren't necessary to keep income taxes low. In later years, when profits start growing, the extra expense helps keep the tax bill to a minimum.
The calculation for straight-line depreciation is straightforward. Take the total original cost of the asset and divide that by the asset's useful life (usually taken from the MACRS asset class listing). The result is the annual depreciation expense, which is the number you'll use every year except the first and last.
For those years, you can go with 50 percent, to mimic the half-year convention, or figure out the true proportion. For example, if you bought the asset in February, you could multiply the total expense by 10/12 for the first year; you would use 10 instead of 11 because March would be the first full month the asset was in use.