Depreciation is a deduction from income tax that lets your firm recover the cost of property. Read on to see how the IRS allows for the wear and tear, deterioration or even obsolescence of items.
The depreciation of tangible property — buildings, machinery, vehicles, furniture, equipment and even cell phones — as well as intangible property, such as patents, copyrights and computer software, is allowed by the IRS in certain situations, and can be used to offset income from your business. Does your property meet these requirements?
- You own the property
- You lease the property and make capital improvements
- You use the property in business and for personal purposes (In this case, you can only deduct depreciation for business use of the property)
- The property has a determinable useful life of more than one year
However, not everything can be depreciated. For example, land is off the table because it doesn’t get used up and is not subject to wear and tear. Inventory is not depreciated either.
You depreciate an asset over time. When you place property in service to use in your business or trade or to produce income, that’s when depreciation begins. However, property stops being depreciable when you’ve fully recovered the property’s cost or other basis or when you retire it from service — whichever happens first.
There are different schedules for different items. For computers, office equipment, cars, trucks and appliances, the recovery time is up to five years. Office furniture and fixtures work on a seven-year schedule. Residential rental properties can be recovered over 27.5 years, while commercial buildings and nonresidential properties can be recovered over 39 years, depending on the year you acquired them.
There are three basic depreciation methods. Particular situations will dictate which ones are most appropriate for you. Keep in mind that you need to know the initial cost of the asset and how long you can depreciate it for.
- Straight line — Depreciate the property an equal amount each year over its useful life
- Accelerated method — Take larger depreciation deductions in the first few years of the property’s useful life and smaller deductions later on
- Section 179 deduction — Deduct the entire cost of the asset the year it’s acquired
To ensure that you properly depreciate property, you need to consider:
- The depreciation method for the property
- The class life of the asset
- Whether the property is “Listed Property” as defined by the IRS
- Whether you’ve elected to expense any portion of the asset
- Whether you qualify for any bonus first-year depreciation
- The depreciable basis of the property
Use depreciation to decrease your company’s tax burden, as you are lowering your overall taxable income. Depreciation doesn’t affect your company’s cash flow or its actual cash balance — it’s a non-cash expense. But before making any decisions, remember to consult your tax professional.