How To Depreciate Equipment?
When you buy an expensive piece of equipment for your business, you can take a deduction on your taxes. However, when this equipment is meant for long-term use, you’ll need to spread the cost of the deduction over the life of the equipment. The method of finding this cost is depreciation.
Depreciation can be simple, with the deduction being the same each year. Or you can use what’s called an accelerated depreciation method to get a higher deduction for the first few years. There are a variety of equations accountants use to calculate depreciation. Which they use will largely depend on how quickly the equipment’s value decreases and the specific industry they work within.
What Types of Equipment Depreciate?
The IRS calls any property that can depreciate capital assets. In general, anything you use for more than two years that helps you produce income will qualify as a capital asset. These are usually big-ticket items like:
● Restaurant equipment.
● Construction equipment.
● Computers and other long-lasting technology.
● Factory equipment.
On the other hand, things you can’t depreciate are smaller items that can contribute to business success, but don’t necessarily help you produce your product or service. Office supplies, for example, won’t qualify. Additionally, some intangible (aka, not physical) assets won’t qualify. This means computer programs, trademarks, and patents won’t often depreciate.
What Is the Equipment Depreciation Rate?
There is no hard and fast rate since it depends on the industry you’re in and the equipment in question. In construction, for example, depreciation can happen in just a few years since the equipment is used daily and is used for tough jobs. Most technology, on the other hand, can last up to 10 years.
How To Calculate Depreciation Of Equipment?
Calculating depreciation can be fairly simple, but as you’ll see is a theme here: it depends on your specific industry and equipment. In general, though, you’ll need the following pieces of information:
● Cost Value: This is the price you originally purchased the piece of equipment for.
● Salvage Value: This is the resale value at the end of the equipment’s life.
● Book Value: The book value is the cost value minus the salvage value.
● Equipment Lifetime: This is simply how long your equipment will last. You can predict the life of your specific equipment by working with an appraiser or asking the company who you bought it from to give you an estimate.
Once you know this information, you can choose a method of calculating depreciation.
Straight-line depreciation is fairly simple. The exact formula is as follows:
Cost value - salvage value / useful life of the equipment = Depreciation
To give you an example - say a farmer buys a tractor for $60,000. The tractor is expected to last eight years and can be scrapped for parts for $10,000 at the end of its life. When he goes to calculate his straight-line depreciation, his equation looks like this:
$60,000 - $10,000 / 8 = $6,250 annual depreciation
Double declining balance
Double declining depreciation allows you to get a higher deduction the first year you own the equipment. You’ll depreciate your asset or assets at double the rate of the straight-line method. This results in a declining deduction as the years go on.
To get the exact calculation, you’ll do exactly as you would in the straight-line method, except you double the annual depreciation for the first year. In the example above with the farmer who bought the tractor, his annual depreciation for the first year would be $12,500.
This method is best used for assets that depreciate quickly in the first few years. Vehicles are the best example here since they depreciate quickly as soon as they’re driven off the lot.
Units of production
The unit of production method doesn’t rely so
heavily on how long you’ll use a piece of equipment, but rather on how much it
can produce. The exact formula is: How the heck do you find those numbers?
Unit Production Rate x Units Produced = Depreciation Expense
Well, the unit production rate is simply the original value of the equipment and you subtract the salvage value. Divide this number by how many units you expect to produce, and bam, you have your unit production rate. The exact equation looks like this
Original Value – Salvage Value / Estimated Unit Production = Unit Production Rate
How the heck do you find those numbers?
Sum-of-years’ digits (SYD)
Like the double declining method, the SYD method accelerates depreciation so you get the highest deduction in the first few years you own the asset. SYD uses the number of years the asset is expected to last and adds together the digits. For example, if the new oven you just bought for the restaurant you’re opening has a life expectancy of seven years, you’d add 7 + 6 + 5 + 4 + 3 + 2 + 1. This equals 28. You’ll then divide each year by this number to get the depreciation percentage for each year.
So, this is the depreciation percentage (rounded up) for each year you’d own the oven:
● 7 / 28 = 25%
● 6 / 28 = 21%
● 5 / 28 = 18%
● 4 / 28 = 14%
● 3 / 28 = 11%
● 2 / 28 = 7%
● 1 / 28 = 4%
The SYD method is best used for quickly depreciating assets since you’ll get the highest deduction in the first year.
How to choose the right calculation method for your business?
When it comes to how to calculate depreciation of equipment, there are a number of methods that work best for certain industries. Here’s a sampling of who these methods may be best for:
● Straight-line depreciation is right for…those looking for the simplest method of depreciation. You’ll get an even rate of depreciation over the life of the asset, so it’s also better for equipment that doesn’t lose value quickly. Additionally, if you predict that you could end up in a higher tax bracket down the road, the straight-line method is a better option. That way you can secure a higher deduction later on, rather than taking a higher one in the first few years when your income is lower.
● Double declining balance depreciation is right for…businesses that frequently buy pieces of equipment that depreciate quickly. This can be vehicles or heavy-duty equipment that takes a lot of wear and tear.
● Units of production depreciation is right for…businesses that use their equipment for regular production purposes. If your equipment doesn’t necessarily last long, but it can produce a lot, you could potentially secure a better deduction using this method.
● SYD depreciation is right for…businesses that hold assets that depreciate quickly, similar to the double declining depreciation.
What Are The Benefits of Depreciation?
Understanding your business’s equipment depreciation can help you understand a number of things about your business. Here are two specific benefits you’ll see by calculating the depreciation of your assets.
● Taxation write-offs. Predominantly, your accountant will calculate depreciation on any assets you have in order to get you a deduction on your taxes.
● Helps to make decisions on repairing the assets. Understanding depreciation helps you understand the true value of your assets. If you find that a piece of equipment is on its last legs, understanding how much it has depreciated can help you understand if it’s worth repairing or if you should just buy new.
How To Report Depreciation on Your Tax Return
When filing your taxes, you’ll calculate and record any depreciation deductions on IRS Form 4562, as shown below.
The IRS offers step-by-step instructions on how to fill out this form, but I’ll explain what each part consists of:
Part I: This first part is all about the Section 179 deduction. In simplest terms, this deduction allows business owners who purchase qualifying equipment or machinery and get the full deduction the first year they own or finance it.
Part II: The next part focuses on the special depreciation allowance. If you have qualifying property (listed on page 5 of the IRS instructions), you can get an additional deduction the first year your equipment is bought and used.
Part III: If you plan to use an accelerated depreciation method, you’ll need to fill out this section. The MACRs (Modified Accelerated Cost Recovery System) depreciation method is a common accelerated method used by the IRS. It’ll allow you to take a larger deduction your first year and have it slowly decrease throughout the life of the equipment.
Part IV: Even though the “Summary” section of the form is placed in the middle, this is simply where you add up your totals from Parts I, II, III, and V.
Part V: If you have any equipment that’s both for personal and professional use, you’d list that here. You’ll split up the items based on if they’re used more for personal or professional reasons.
Part VI: This final section is in regards to amortization. That’s essentially depreciation of intangible (or not physical) assets like copyrights and patents.