What Is Depreciation?
Depreciation is a deduction in the value of an asset with the passage of time (due mostly to wear and tear).
In terms of accounting, depreciation is useful because it allows you to more accurately calculate the true value of a business asset.
In terms of taxes, you can write off the depreciation of tangible assets each year based on the useful lifespan of the asset (with each asset being different) and other factors.
What’s considered an asset?
Before we go on, it’s important to understand what the IRS considers an asset. An asset is considered to be anything with a monetary value, whether tangible or intangible.
Tangible assets include property, vehicles, as well as the type of equipment from computers to machines. Intangible assets include copyrights and various forms of intellectual property.
Surprisingly, the IRS allows you to write off both tangible and intangible assets, the depreciation of intangible assets being referred to amortization.
Where Is Depreciation Listed on a Tax Return?
Depreciation is typically listed in the deductions section of your tax return.
For example, if you’re doing your corporation taxes, you’re likely using IRS Form 1120 for your tax return.
On Form 1120, your depreciation total (taken from Form 4562, more on that below) is listed here:
Keep in mind that your tax return isn’t a replacement for Form 4562, which you’ll need to fill out to properly report any depreciation deductions.
How Does Depreciation Work?
Based on IRS guidelines, depreciation expense is considered a non-cash transaction. However, you are allowed to write off that depreciation on your taxes.
The basic idea is this: If you buy several large bottling machines for your warehouse, each year those machines depreciate a certain percentage in value.
Whatever dollar amount that equates to, you can write it off for that year.
*Side note: Accumulated depreciation is a common term thrown around in conversations on depreciation. It refers to the cumulative depreciation an asset has amassed over its life.
How to Calculate Depreciation
The basic depreciation formula is this:
Purchase value – Current value / Asset lifespan = Depreciation value
For example, if:
- The value of one of those bottle machines was $25,000 when you bought it
- Its current salvage value is $5,000
- And the asset’s lifespan 10 years
That would make your depreciation value $2,000, which would be the amount you could write off on your business taxes that year.
*Tip: If you’d prefer to calculate depreciation yourself or simply would like to get an idea of what the depreciation of an asset might be, you can use one of countless depreciation calculators online such as Calculator.net’s depreciation calculator.
However, having said this, keep in mind that it’s best to let your accountant or tax software calculate depreciation for you.
Modern depreciation calculation methods such as the MACRS depreciation table use specific depreciation values based on IRS codes, so it’s best to go with a professional (or professional software/service) to accurately calculate depreciation.
A note on writing off depreciation on your taxes
It’s important to note that while we just spoke about writing off a single year’s worth of depreciation of an asset’s value on your taxes (in the example case, $2,000), it is possible to simply write off the entire depreciation value in a single year.
This is called accelerated depreciation.
It’s an option you can take advantage of if you decide that writing off a larger portion of an asset’s depreciation in the early years of an asset’s life makes sense for your business.
Types of Depreciation: 3 Depreciation Methods
There are several different types of depreciation. Or ways an asset can depreciate.
Depending on which method you use will determine how much of that asset’s worth you can write off on your taxes each year.
There are 4 main types of depreciation:
- Straight line depreciation
- Double-declining depreciation
- Sum-of-the-year’s-digits depreciation (or simply SYD depreciation)
- Units of production depreciation
Let’s break down each depreciation method to clarify the differences:
Straight line depreciation
Straight line depreciation is the most standard depreciation method.
With this method, you write off an equal amount each year based on the annual depreciation of the asset averaged out over its lifespan.
Should I use straight line depreciation?: Consider this method if you’re a small business with a basic accounting system and no special tax needs.
Units of production depreciation
Units of production depreciation is perhaps the most unique in that it’s based on how much you use the asset.
A machine you use frequently for production, a vehicle for deliveries, or an oven you use each day for cooking are examples of depreciating assets which might use this method.
With this form of depreciation, how many units (or similar) the asset has produced multiplied by the dollar value of the units is how you calculate the amount you’re able to write off.
Should I use units of production depreciation?: Any business looking to write off depreciation from daily-use equipment with quantifiable production numbers.
Double-declining depreciation and SYD depreciation
Double-declining depreciation and SYD depreciation are both types of accelerated depreciation, which we touched on earlier.
With both, you can write off more of the value of an asset in advance (up to the full value of an asset in a tax year in some cases).
However, with double-declining depreciation, you get most or all of the depreciation value up of the asset upfront.
Whereas with sum-of-the-year’s digits depreciation, that value is condensed into the first several years while that asset’s lifespan is reduced by an additional each year tax year.
Should I use double-declining depreciation?: Small businesses who had lots of expenses opening up shop and are looking to get a good return on their investment with Uncle Sam.
Should I use SYD depreciation?: Similarly, for those looking to get more of their asset’s depreciation upfront but who would rather have that value distributed over several years.
What Assets Can You Depreciate?
Now to the fun stuff. What assets can you write off on your taxes?
I get it, you’re dying to know.
First, to write off the depreciation of an asset on your taxes, that asset must meet these IRS-designed criteria:
- You must own the asset
- You must use the asset
- You must expect the asset to last more than one year
- And you must be able to calculate the asset’s useful life
In terms of what is depreciable, assets include:
- Property you own such as office buildings and those for the purpose of rental income, including both commercial and residential
- Improvements to property which you rent
- Vehicles
- Equipment such as computers as well as machinery
- And intangible assets such as copyrights, software, and patents
If the asset in question meets the IRS guidelines above as well as fits within the list of depreciable assets just mentioned, the asset’s depreciation can likely be written off on your business taxes.
However, it’s important to check with a professional about your depreciable assets and refer to their guidance.
That includes both how much of an asset’s value is depreciable and what your best move is in terms of how much of your asset’s value should be written off on a particular tax year.
What doesn’t depreciate?
The list of assets above is long and includes most of those assets a business tends to use and accumulate, but it doesn’t include everything.
These assets don’t (solely) depreciate in value and therefore no part of their value can ever be written off:
- Investments (such as stocks)
- Collectibles (such as art and coins)
- Land
- Property which you aren’t using either for business purposes or to collect rental income
IRS Tax Forms Associated with Depreciation: Form 4562 and More
The primary IRS tax form related to depreciation is Form 4562.
IRS Form 4562 is used to record depreciation and amortization for items and property you’ve purchased for your business.
You’re required to fill out Form 4562 if any of the following apply to you:
- You have large purchases you need to deduct depreciation on, such as a vehicle or property
- If you’re listing any kind of depreciation on a corporate tax return (other than 1120S)
- Section 179 expense deduction
- Or amortization of costs for said tax year
Learn more about IRS Form 4562 in our guide here: How to File IRS Form 4562: Step-by-Step Instructions.
Other tax terms related to depreciation include:
- 1031 Exchange: Allows you to defer taxes which you owe for depreciation recapture. Learn more: 1031 Exchange: How It Works.
Make the Most of Depreciation
Depreciation is a useful accounting principle to understand.
Not only can it save you money on your taxes each year, depreciation you write off can artificially boost your revenue on your tax return, which has its own benefits as well.
At Excel Capital, we understand that cash doesn’t always flow into your business at the right time and every bit counts.
Sometimes, a bit of capital can be just what you need to get through a rough patch or make that key investment that takes your business to the next level.
We’ve helped thousands of business owners obtain the capital they need to move their business forward.
Apply with Excel Capital today:
Get the capital your business needs– fast. Apply for a small business loan with Excel Capital:
