What Is Tax Depreciation?

Depreciation is an accounting method of allocating the cost of an asset over its useful life. It results in depreciation expense, an income statement item, and accumulated depreciation, a balance sheet item. Depreciation expense indicates the amount of an asset that has been used up in the period. Accumulated depreciation, which is a contra asset (an offset to a traditional asset), represents the inception-to-date accumulation of depreciation expense.

Tax depreciation refers to the depreciation expense a business is permitted to deduct for tax purposes. It is specified by the Internal Revenue Service (IRS) and doesn’t usually align with the depreciation expense reported on a company’s financial statements. Read on to learn more

Accounting is a detail-oriented profession that can be boring and confusing for a lot of business owners. It’s natural to get frustrated, but don’t ignore this important aspect of your business. Keeping organized financial records is essential to making smart decisions and growing your business. It can also help you save a lot of money on taxes. One of the most powerful ways to do so is via tax depreciation deductions.

What Is an Asset?

An asset is a resource that has the potential to generate economic value now and into the future. Assets can be tangible or intangible. A tangible asset has a physical form; it can be seen, touched, and measured. Examples include real estate property, machinery, automobiles, and inventory. 

An intangible asset is a non-monetary asset that lacks a physical substance and is characterized as either identifiable or non-identifiable. Identifiable intangible assets are those that can be distinguished from other assets and are, possibly, marketable. They include intellectual property, such as patents, copyrights, trademarks, and trade names. 

Non-identifiable intangible assets are those that cannot be distinguished from other aspects of a company. The most common example is goodwill, which is recorded when a company acquires or merges with another company and pays more than its fair value. The difference is goodwill. 

What Kinds of Assets Can Be Depreciated?

Generally, tangible assets are depreciated. A few exceptions pertain to assets that do not necessarily deteriorate with time. This includes land, financial securities, and collectibles, such as art, coins, and memorabilia.

Intangible assets are not depreciated. If an intangible asset has a useful life, it is amortized (the equivalent of a tangible asset being depreciated) over that period. However, if an intangible asset can be renewed easily and without substantial cost, it is considered perpetual and is not amortized. 

An exception to this guidance pertains to goodwill. Goodwill is never amortized. Rather, it is tested annually for impairment and the asset is written down if deemed impaired. If you are looking for more ways to lower your business taxes you might also wish to explore claiming a business loss on taxes.

Fast Fact:

As a general rule-of-thumb, you can only depreciate tangible assets that (1) you own and use for income-producing activities and (2) have determinable useful lives that extend beyond a year.

Book Depreciation vs. Tax Depreciation

Before we delve further into the concept of depreciation, a major distinction is in order – book depreciation vs. tax depreciation. Book depreciation, which is based on the guidelines and standards of generally accepted accounting principles (GAAP), is reported on a company’s financial statements. Tax depreciation, which is stipulated by the IRS, is recorded on a company's income tax returns.

The two forms of depreciation seldom align, especially for companies that maintain sophisticated financial reporting frameworks. Necessarily, this leads to separate records for book depreciation and tax depreciation.

Common Ways to Calculate Book Depreciation

There are various methods of recording book depreciation, all of which, can be categorized as either time-based or activity-based. The former type is used more frequently than the latter, primarily because it’s simpler and less labor-intensive.

By far, the most common way to calculate book depreciation is the straight-line method. It results in an even allocation of the cost of an asset over its useful life. The popularity of this method is due to its easy-to-understand and easy-to-administer nature. Straight-line popularity is enhanced by its consistency and predictability, which can facilitate forecasting efforts.

Straight-line Example:

Assume you just acquired a piece of equipment for a total acquisition cost of $110,000. It has a useful life of five years and a salvage value (the amount you can get by scrapping it at the end of its useful life) of $10,000. Based on these attributes, the annual depreciation expense is computed as follows:

Annual Depreciation = (Cost – Salvage Value) ÷ Useful Life

Annual Depreciation = ($110,000 – $10,000) ÷ 5 = $20,000 

Other fairly common methods of depreciation include the double-declining balance method, the sum-of-the-years’ digits method, and the units of production method. Check out the following site for a detailed example of how each is calculated: examples of common depreciation methods.

Calculating Tax Depreciation

Any of the depreciation methods noted above can be used to calculate book depreciation. However, when it comes to calculating tax depreciation, business owners do not have much leeway. For assets placed in service after 1986, tax depreciation must be calculated using the modified accelerated cost recovery system (MACRS).

The MACRS system consists of a set of depreciation tables reflecting the spectrum of assets in question. There are several distinct tables for assets other than real estate (with useful lives ranging from 3 years to 25 years) and distinct tables for real estate property (with useful lives ranging from 27.5 years to 39 years). In addition to the useful life (or recovery period), each table includes the convention logic for purchases and disposals (mid-month, mid-quarter, or mid-year) and the depreciation percentages associated with each year of ownership.

To compute depreciation for a given year, you simply multiply an asset's depreciable base by the percentage indicated for the year of focus. Additional instructions and the actual tables can be found at the following site: IRS Publication 946, How to Depreciate Property.

How Does Depreciation Impact My Taxes?

Tax depreciation reduces the amount of earnings on which a company’s taxes are based. As a result, it reduces the amount of small business taxes owed. Essentially, the more tax depreciation claimed, the lower the tax bill – which is why depreciation is commonly referred to as a tax shield. This concept is simple, but the process of filing a tax depreciation deduction is more complicated. 

Refer to IRS Form 4562 for more information on what you need to do to claim tax depreciation or see self employed tax deductions for more general details. 

Note:

MACRS allows for faster depreciation in the early years of an asset's life than the straight-line method. This is ideal, because it facilitates the realization of greater incremental cash flows in an asset’s early years, thereby positioning a business to earn a higher return on investment over the long term.  

Other Frequently Asked Questions

Is depreciation a fixed or variable expense?

With time-based methods, depreciation is generally considered to be a fixed expense, even though the amount of depreciation recorded from period-to-period can change.  With activity-based methods, such as units of production, depreciation is variable and proportional to a specified driver.

Is depreciation always beneficial for a business?

Claiming tax depreciation isn’t mandatory, but not doing so is generally a big misstep for business owners for the following reasons:

     a) Claiming depreciation deductions is a way to accelerate after-tax cash flows and enhance your return on investment. 

      b) If you don't claim permissible depreciation on an asset, you will still be treated as having claimed it at disposal. This means you'll have an inflated capitalized gain to report, but you will have lost out on the deductions against ordinary income you could have claimed over the years. In other words, you will lose money at sale.

That said, unless you’re knowledgeable about accounting and proficient in handling tax depreciation matters, the cost of hiring the resources you need could be more costly than forgoing your depreciation deductions. The trade-off is situational. Ultimately, you should consult with a tax professional on a fee-free basis to assess things.

What is a tax depreciation schedule?

A tax depreciation schedule is a spreadsheet that itemizes your depreciable assets and shows how each is depreciated over time. It captures historical detail and can be used to highlight imminent transactions that need to be recorded. Generally, the following information is included on a tax depreciation schedule:

-Asset description
-Purchase date
-Total acquisition cost
-Useful life projection
-Method used to calculate depreciation
-Salvage value
-Depreciation for the current accounting period
-Cumulative depreciation
-Asset net book value (acquisition cost less cumulative depreciation)

See the snippet below for a simplified illustration.

How long can I claim depreciation on an asset?

Generally, depreciation can be claimed, until one of the following circumstances is met:

-The total depreciable base of the asset has been deducted.
-The asset ceases to be income-producing and is retired from service, donated, sold, converted to personal use or destroyed.

What is IRS Section 179?

Section 179 of the U.S. Internal Revenue Code is a rule allowing businesses to deduct the entire cost of certain assets in the year acquired, up to a maximum of $1,080,000 in 2022. If total acquisitions are greater than $2,700,000, the maximum deduction begins to be phased out. Deductions that are not used in the current year can be carried over to future years.

What is IRS Section 1250?

Section 1250 of the U.S. Internal Revenue Code is a rule stipulating that the IRS will tax a gain from the sale of depreciated real property as ordinary income – if the accumulated depreciation on the asset exceeds the depreciation calculated under the straight-line method. Essentially, this enables the IRS to recoup any tax savings you achieved by accelerating the property’s depreciation prior to sale.

What other types of expenses can business owners write off?

In addition to tax deprecation, there are several other tax deductions that can reduce your tax bill. The most prominent expense write-offs are outlined below.

- Self-employment tax – With this deduction, you can deduct half of your FICA tax from your net earnings when calculating taxable income. Essentially, this reduces your Social Security and Medicare tax obligations to a level that approximates that of traditional employees.

- Home office – This is a complex deduction, covering the cost of any workspace expenses you incur regularly and exclusively for your business. This includes a portion of your rent or home depreciation, utilities, property insurance and repairs and maintenance expenses.

- Health insurance premiums – If you are self-employed, pay health insurance premiums and are not eligible to participate in a plan through your spouse’s employer, then you can deduct all of your qualified health, dental and long-term care insurance premiums. Additionally, certain medical and dental expenses above 7.5% of your adjusted gross income may be tax deductible.

- Other expenses – In many cases, you may have deductions available that relate to a host of other business-related expenses, including liability insurance, advertising, travel, education, publications and subscriptions, loan interest and charitable contributions.

When should I consult with a tax professional?

Tax depreciation is a fairly straightforward concept, but the accounting methods and IRS guidelines governing it are layered with complexity. As a result, unless you have a strong understanding of things and a limited number of depreciable assets, consulting with a tax professional is strongly advised. It will cost a bit upfront, but the time and money you’ll save over the long run could be substantial. 

Sources:

Accounting.com. (2022, May 2). What Is GAAP? Retrieved from https://www.accounting.com/resources/gaap/

Corporate Finance Institute. (n.d.). Depreciation Methods. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/accounting/types-depreciation-methods/

Corporate Finance Institute. (n.d.). Intangible Assets. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/accounting/intangible-assets/

Internal Revenue Service. (2022, March 7). Publication 946 (2021), How to Depreciate Property. Retrieved from https://www.irs.gov/publications/p946#en_US_2021_publink100097624
Internal Revenue Service. (2022, February 3). About Form 4562, Depreciation and Amortization (Including Information on Listed Property). Retrieved from https://www.irs.gov/forms-pubs/about-form-4562