With the year in full swing, it’s time to tackle your taxes.
But before you file your taxes as a business owner, it’s important to understand which tax deductions your business is eligible for. And one tax deduction that is sometimes overlooked and often misunderstood is depreciation.
So, in this article, we’ll explain how depreciation works and which assets cannot be depreciated, so it may amplify your tax benefits. Let’s get started.
What Is Depreciation and How Does it Work?
Depreciation is the decrease in the value of an asset because of its continuous deterioration over its useful life. This allocation of cost recognizes the gradual decrease in the asset’s value due to factors like technological advancement, wear and tear, and obsolescence.
Cost accountants use depreciation to know the cost of producing goods and services as well as track expenses associated with the use of assets. Depreciation is further classified as an indirect cost or an overhead expense in cost accounting, and it’s allocated to products or services, depending on the asset’s contribution to the manufacturing process.
Depreciable assets are business assets qualified for depreciation based on IRS Publication 946.
Which Assets Can Be Depreciated?
Several types of assets can be depreciated, including commercial and residential buildings, vehicles used for business purposes, machinery and equipment, capitalized research and development costs, leasehold improvements, and leasehold rights.
Assets depreciate because of physical deterioration or economic use. Physical deterioration happens when the asset loses its original cost because of wear and tear, natural disasters, or accidents.
Economic depreciation or use, on the other hand, occurs when there’s a decline in the economic value of an asset over time. This depreciation usually occurs in the real estate industry.
Some assets depreciate slowly, while others quickly, and some are more sensitive to depreciation than others. Cars, for instance, lose their value quickly because of wear and tear.
Writing off depreciable assets enables you to lower your tax liabilities.
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How Do You Calculate Depreciable Assets?
It is mandatory in the US for accountants to calculate depreciation per rules set by the GAAP-Generally Accepted Accounting Principles.
To calculate the total depreciable assets each year, consider the initial cost of the asset, the depreciation method being used, and the estimated useful life of that asset.
Here are the steps to calculate the total amount of depreciation each year.
Step 1. Identify the original cost of the depreciable asset
Begin by determining the initial cost or purchase price of the asset. Aside from the purchase price, include also costs incurred in bringing that asset into use, like installation and transportation expenses.
Step 2. Estimate its useful life
For the second step, estimate the total production units or the number of years it will be useful to your business. The estimated useful life may be determined based on asset-specific guidelines or industry standards or your own experience with similar assets.
Step 3. Determine the estimated salvage or residual value
Consider the estimated salvage or residual value of the asset during the end of its useful life. It’s the expected value of the asset once it has depreciated or fully utilized.
Step 4. Choose an appropriate depreciation method
Select an appropriate depreciation method based on your accounting regulations, business needs, and tax considerations. This method could be the following:
Declining balance depreciation - This method is an accelerated depreciation method. It assumes that an asset will generate more revenue in the year years and puts a higher depreciation expense in those years.
Here is its formula:
Depreciation Expense = (Net Book Value – Accumulated Depreciation) x Depreciation Rate
Net Book Value is the original cost of the asset less the accumulated depreciation.
Meanwhile, the Accumulated Depreciation is the total depreciation expense since the asset was acquired. The Depreciation Rate is calculated as a percentage by dividing the straight-line rate by a specified factor.
Straight line method depreciation - This method reports the same depreciation expense every year throughout the entire useful life of an asset until it is depreciated to its salvage value. This is the most basic way to record depreciation.
Depreciation expense may be charged on the fixed asset that is a part of income-producing activity or is used in business.
Here is its formula:
Straight-line depreciation Expense = (Cost of Asset - Salvage Value)/ Useful Life of an Asset
Asset Cost is the original cost of the asset. Salvage Value is the estimated residual value of the asset at the end of its useful life, while Useful Life is the estimated duration where the asset can be utilized.
Units of production depreciation - It is a method of depreciation that calculates the asset’s value based on its usage. This depreciation method is best for assets consumed over time or commonly used, like mining equipment, manufacturing machinery and vehicles.
Here is its formula:
Depreciation Expense = [(Original Value- Salvage Value)/ (Estimated Production Capability] x Actual Number of Units Produced
Sum of the year’s digits depreciation - This method segregates yearly depreciation into fractions and takes into account the number of years of the asset’s usefulness. The method is more rapid than the straight-line method but less rapid than the double-declining method.
Compared to other accelerated methods, this accounting method suits assets with higher production capacity in their initial years.
Here is its formula:
Sum of year’s digits depreciation = (Number of useful years/ total of useful years) x depreciable amount
Depreciation is a non-cash balance, so it doesn’t affect the actual cash balance of the business. However, it lessens the net profits as shown in the company's income statement. This is why it reduces one’s taxable income and lessens the tax burden of the company.
Now that you know the assets that can be appreciated and how to calculate them, let’s focus on the ones you can’t claim depreciation for.
Characteristics Of Depreciable Assets
1. They have a useful life of over one year - Depreciable assets are expected to last for a minimum of 12 months from their acquisition.
2. They have an estimated useful life - They have a limited useful life. For instance, library books may last not longer than ten years before they need to be replaced with newer editions, while software may last only five years before needing replacement.
If the asset has an unlimited useful life, it is not a depreciable asset in accounting because it can be practically used forever without a reduction in value.
3. Their value must decrease over its useful life - Another characteristic of depreciable assets is their value is expected to reduce than their original cost to the business.
4. They are physical objects - These are physical properties that can be touched or seen, such as a building or a car. They include all tangible fixed assets used in a business.
Accountants don’t depreciate intangible assets like patents and software. Instead, they amortize those assets, which is almost the same as depreciation but with separate accounting rules.
5. The business has a right to control the asset - Businesses can only depreciate their assets. For instance, an airline can depreciate the aircraft it effectively owns but not the ones it hires temporarily in expectation of a busy season.
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Asset That Cannot Be Depreciated
The list of assets that do not depreciate includes:
Land as a Non-Depreciable Property
Land is a unique asset that does not depreciate because it has an infinite useful life. Further, its value tends to increase over time due to the scarcity of land as opposed to the decline in the value of other types of fixed assets.
When a business purchases land with a building on it, the cost is allocated between the two properties, resulting in the depreciation of the building but not the land. It also doesn’t depreciate because it does not diminish in quality or quantity through regular use.
The only exception to the rule is that land is a non-depreciable property when some parts of it are used up, like it’s a mine that’s emptied of its reserves.
Components of Land
Certain developments and improvements made to the land, like landscaping, land development costs, and buildings, may be subject to depreciation, but it does not decrease because of their inherent characteristics.
Intangible Assets
These assets lack physical substance, including patents, copyrights, brands, goodwill, and trademarks. The reasons for the non-depreciation of intangible assets are as follows:
Amortization as an alternative - Intangible assets are typically amortized rather than depreciated (applicable for tangible assets). It’s the same concept, but amortization pertains to the allocation of the asset over its useful life.
Indefinite useful life - Intangible assets have an uncertain or indefinite useful life, which makes it a challenge to determine the exact period for depreciation.
Personal Property Not Used for Business
Another asset that cannot be depreciated in accounting is the business owner’s personal property, such as a private car or personal residence. Any personal properties that belong to the employees of the business are also non-depreciable assets.
Investments In Financial Instruments
Investments in financial instruments, including mutual funds, bonds, and stocks, can't be subject to depreciation for two reasons:
Short-term holding period - Investments in financial instruments are typically meant for short-term holding and not long-term use.
Marketable securities - These assets are marketable securities and are accounted at fair value, which fluctuates according to market conditions.
Natural Resources
Oil, gas, forests, mineral deposits, and other natural resources are non-depreciable assets because of their unique characteristics. Rather than depreciation, they are accounted for utilizing the depletion methods that apportion the extraction cost over the estimated reserves.
What Is a Depreciation Tax Shield?
This is the tax saved from reducing the depreciation expense from the taxable income. The use of this tax shield is most applicable in asset-intensive industries, wherein large amounts of fixed assets may depreciate.
Here is the formula for calculating the depreciation tax shield:
Depreciation Tax Shield = Depreciation Expense x Tax Rate
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Benefits to Hiring an Accounting Firm
Minimize Errors
When data entry, complex math, and number crunching are mismanaged, they could lead to technical errors.
Outsourced accounting services can help you reduce overall errors related to your finances because they have team members who are typically at the top of their field with specialized knowledge in diverse industries and experience in finance.
With a team overlooking your finances, they can quickly discover errors and correct them. This also allows you to discover potential issues early or before they can affect your business.
Increase Flexibility
Flexibility is a strength when competing in your industry, and that’s exactly what accounting services can provide to you. It can keep your business flexible.
You’ll have a centralized accounting process without having to bounce between departments, wait for follow-ups from different team members, or ping some people back and forth.
Keep the Costs Down
Accounting firms can help cut the cost of your firm efficiently. They’re experts in their field and most likely handle many clients, making them aware of the common mistakes that cost companies lots of money.
Accounting firms can help you avoid mistakes and analyze ledges to advise you on saving money. They can also keep a keen eye on your accounting transactions to avoid mistranslations and fraud in the company.
Prioritize Scalability
Accounting services scale a business by removing the risk of extended hiring, onboarding, retraining, employee turnover, and an increase or decrease in client demand.
Final Thoughts
Asset depreciation reduces the tax burden on the business because it is used to lower the taxable income. However, depreciation is considered a non-cash expense and will not affect your actual cash balance or cash flow.
You can’t depreciate property for inventory, personal use, assets held for investment purposes, or assets that don’t lose their value over time.
If you improve depreciable property, such improvement should be treated as a separate depreciable property, at least for tax purposes.
And finally, despite having several methods of calculating depreciation, choosing a method that is appropriate for your business is essential for estimating the future net cash flow of the business.
Looking for a full-service accounting firm that can help you stay financially organized and tax compliant?
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