Small business owners often pay more in taxes than they need to. They may be reluctant to take deductions and credits out of fear that the Internal Revenue Service will audit them. Or they may miss some of the nuances when filing their tax return because they’re not trained as accountants.
At Cook Martin Poulson, we work with small business owners every day and one of our priorities is helping them minimize their tax burden. Since many small businesses miss out on effectively utilizing the depreciation deduction, we have written this post to help you understand what it is, how it works, and how much you can claim to reduce your tax liability.
What is Depreciation?
Let's start with a basic definition of depreciation. The IRS defines depreciation like this:
Depreciation is the recovery of the cost of the property over a number of years. You deduct a part of the cost every year until you fully recover its cost.
In other words, depreciation is a calculation that allows small business owners to reduce the value of an asset over time. A variety of things, including age, wear & tear, or even decay, can reduce the value of an asset such as a vehicle or a piece of office equipment. You can recoup the expenses of buying an item through depreciation.
IRS Depreciation Rules
As you would expect, the IRS has laid out a set of special rules for depreciation deductions. Before we explain how to deduct depreciation, let's review those rules.
The rules dictate which types of property may be depreciated. To meet the IRS requirements, the qualified property must meet all the following criteria:
- You must own the property. For depreciation, ownership applies even if you have borrowed money to buy the property being depreciated. For example, if you buy a commercial vehicle with a loan, you may depreciate it.
- It must be used either in your business or in some other income-producing capacity. The IRS rules allow for items that are used in a business to be used for personal purposes. However, you may deduct only the percentage of use that applies to your business. Personal property that is only for your personal use may not be depreciated.
- It must be intended to last for more than one year. Depreciation is not meant to reimburse small business owners for the use of disposable items such as office supplies. Any item you purchase for business use that is intended to last for more than 12 months may be depreciated with some exceptions that we'll discuss below.
- The property must have a determinable useful life. Finally, a depreciable property must have a definable lifespan. The IRS says that it must be "something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes".
According to the IRS, small business owners can depreciate most real property, including buildings, equipment, office furniture, machinery, and vehicles. The land is the only tangible property asset that may not be depreciated.
In addition to the above tangible assets, you can also depreciate certain types of intangible property, including computer software, copyrights, and patents.
Here are the exceptions to the depreciation rules, which focus mostly on items that may not be depreciated.
- Items that are placed in service and disposed of within one year may not be depreciated.
- Depreciation on equipment used to make capital improvements must be added to the basis of your improvements and may not be deducted.
- Section 197 intangible property must be amortized. These intangibles are defined as property acquired after August 10, 1993, with the property in question being acquired as part of a business acquisition. These items include goodwill and other intangibles. You can find the full rules here.
- Property owned by people in certain relationships related to your business may not be depreciated.
As the rules of depreciation are complex, the best option is to hire an experienced business accountant to help you properly depreciate your business property without attracting unwanted attention from the IRS.
How Does Depreciation Affect Taxes?
Depreciation is beneficial to businesses because it allows them to reduce the number of their taxable earnings.
In other words, claiming depreciation indirectly reduces your taxes because it lowers your tax basis. Depreciation doesn't directly reduce the amount you owe because it's not a tax credit. Instead, it reduces the amount that you must use to calculate your business's taxable income.
Is Depreciation Tax Deductible?
As you may have guessed from the previous section, depreciation is a tax deduction. As a reminder, a tax deduction is something that reduces your taxable earnings. If your business earned $1 million and you had $100,000 of qualified depreciation, the taxable income for your business would be reduced to $900,000.
A tax credit is something that directly reduces the amount you owe. For example, if you owed $100,000 and qualified for tax credits totaling $10,000, you would owe $90,000 after utilizing the credits.
We will explain the process for calculating and claiming the depreciation tax deduction for an eligible class of property later in this post.
What is the Special Depreciation Allowance?
The special depreciation allowance has been in existence for years but there have been some changes to it thanks to the Tax Cuts and Jobs Act (TCJA) of 2017. Before the passage of the TCJA, the special accelerated depreciation allowed businesses to deduct 50% of the expenses associated with acquiring qualified property in the first year that the property was put into service.
The TCJA increased the amount of the special depreciation allowance to 100%. The special allowance applies to depreciable property with a recovery period of 20 years or less, as well as to some other types of property.
The eligible property that usually qualifies for the special depreciation allowance includes:
- Office furniture
The 100% deduction applies to any qualifying property that was purchased and placed into service after September 27, 2017. We should note here that used property may also qualify for the deduction.
There are special rules in place to address the status of the self-constructed property where production began before September 28, 2017. The purpose of the special depreciation rule is to help businesses defray the expenses associated with acquiring qualified property in the same year they acquired it instead of writing off the expense slowly over a long recovery period.
The final thing you need to know about the special depreciation rules is that enrollment is automatic. You may opt out, but you must explicitly do so if you do not want to claim the entire cost in the first year. This election is on a per-class basis (all 5-year property, all 7-year property, etc.).
How Is Depreciation Calculated for Tax Purposes?
If you elect not to claim 100% depreciation in the year you acquire a depreciable asset, there are multiple depreciation methods that you or your accountant can use to calculate depreciation for tax purposes.
By far the most understood method used to calculate depreciation is the straight-line method. To use it, take the asset's expected salvage value and subtract it from the asset's cost. Then, take the resulting number and divide it by the number of years you expect to use it.
Unit of Production Method
For any type of depreciable property where the value is more closely related to the frequency of its use than to its age, the unit of production method is beneficial. It allows businesses to claim more depreciation in years when an asset is heavily in use and less in years when it is not.
Declining Balance Method
The declining balance method is most implemented to depreciate property eligible for depreciation where the depreciation schedule is accelerated. For example, electronics become obsolete more quickly than machinery in most cases. You can use this depreciation method to keep your deduction in line with the value of the property in service.
The double-declining method is another accelerated depreciation calculation that allows businesses to depreciate more in the early years of putting property in service and less in its later years. Like the declining balance method, it tends to be used for property that depreciates quickly.
Finally, you can use the sum of the year's digits to accelerate depreciation and reduce your taxable business income. With this method, you add the years of depreciation together. With a five-year property depreciation, you would add 5+4+3+2+1 to get 15, then divide the current year's depreciation by the total. So, in the first year, you would divide 5 by 15 to get 33% depreciation, and so on. A 15-year property would add the number 1 through 15 and proceed accordingly.
Choosing the right method of depreciation will help you to save money when you file your federal return and take your annual depreciation deduction.
How Much Depreciation Can You Write Off?
The TCJA increased bonus depreciation but that's not the only thing that it changed. It also increased the limits that businesses can claim for the depreciation deduction and increased the phase-out for those deductions.
Let's look at the limits first. Before the TCJA, the Section 179 maximum deduction for depreciation was capped at $500,000. The TCJA adjusted it as follows, with mandated increases for each tax year.
- 2019: $1,000,000
- 2020: $1,040,000
- 2021: $1,050,000
- 2022: $1,080,000
At the other end of the spectrum is the phase-out of the allowable bonus depreciation deduction. After the limits established by the TCJA and the IRS, businesses will experience a dollar-for-dollar reduction in their allowable depreciation after reaching the following limits.
- 2019: $2,500,000
- 2020: $2,590,000
- 2021: $2,620,000
- 2022: $2,700,000
We should note that the Section 179 deduction limitations and phase-out threshold are now a permanent part of the tax code. However, the TCJA as written will phase out the 100% bonus depreciation amount starting on January 1, 2023.
- 80% for property put into service after December 31, 2022, and before January 1, 2024
- 60% for property put into service after December 31, 2023, and before January 1, 2025
- 40% for property put into service after December 31, 2024, and before January 1, 2026
- 20% for property put into service after December 31, 2025, and before January 1, 2027
Working with an experienced tax accountant will ensure that you claim the maximum allowable bonus depreciation deduction. It is also important to note that there are separate depreciation limits for vehicles.
How to Claim Depreciation as a Tax Deduction
The process to claim depreciation as a tax deduction requires careful preparation before you file your federal tax return. You'll need detailed information, including the original basis of property acquired for any depreciable business assets.
You should know that to claim depreciation on property placed into service before 1987, you must use the Accelerated Cost Recovery System. For property placed into service after 1986, you must use the Modified Accelerated Cost Recovery System. You can find details in IRS Publication 946.
The proper form to claim depreciation as a deduction for federal income tax purposes is IRS Form 4562. The tax form you will use -- and where you will list the deduction you calculate on Form 4562 -- will depend on your business structure.
- Pass-through organizations will file business expenses, including depreciation, on Schedule C (Form 1040.) Depreciation should be entered in Section II, Line 13.
- C corporations (and LLCs filing as C corporations) will file Form 1120 and claim depreciation there that hasn't been claimed elsewhere. Your depreciation deduction should be entered on Line 20 of the form.
We know that this may be a lot to take in. For most business owners, the solution is to hire an experienced tax professional to help them track and calculate depreciation and file their federal tax returns.
Don't Leave Money Behind, the Depreciation Deduction Can Help You Reduce Your Tax Bill
If you have purchased tangible property or qualified intangible assets for use in your business, then the depreciation deduction can help you to reduce your tax liability. The benefits can be substantial thanks to the special depreciation rule.
The calculations for the depreciation deduction may be complex and confusing. Our experienced business tax accountants are here to help.