What every the equipment, it is going to wear out over time. To mark the wearing out of this equipment, and to record the use of the equipment in your business to make a profit, you record depreciation. This depreciation is tax deductible, and is taken on your schedule C. Let’s take a look at this deduction and how it works.
To Depreciate or Not to Depreciate?
There are certain requirements for you to depreciate a piece of equipment. First, you must own the equipment. You cannot take a depreciation deduction for equipment that you lease or someone else owns (there is a deduction for lease payments, but it is recorded on your Schedule C somewhere else). Second, you have to use it in your business. Just because you have a computer that you use outside your business for personal use doesn’t mean you can claim depreciation on it. Third, it must have a determinable useful life. You can get this from the IRS. It must be expected to last more than one year. Otherwise, you would take the entire cost as a deduction for the current year.
However, there may be times when you meet those criteria, but you can’t take depreciation on that item. If you bought something, started using it in your business, decided it wasn’t right for your business, and got rid of it, you can’t take depreciation on that piece of equipment. Additionally, if you purchased the equipment to make capital improvements (like building an addition to your home for your home office), you cannot deduct depreciation for that item, but would add the otherwise allowable depreciation on that piece of equipment during the period of construction to the basis of the improvements.
How to Calculate Depreciation
So now you know the rules for what you can depreciate. You now need to know what information about that equipment you need to calculate depreciation.
The first thing you need to figure out is the class life. This is based on how long the IRS thinks a particular asset would last, and therefore, over what period you should depreciate the asset. For example, computers have a five year life. The IRS puts out tables showing this information in Publication 946. Use this guide to help you determine over what period to depreciate your asset.
The next thing to determine is if your asset is “Listed Property.” According to the IRS, Listed Property would be one of the following:
- Any passenger automobile or other property used for transportation,
- Property generally used for entertainment, recreation, or amusement. This would include photographic, phonographic, communication, or video recording equipment,
- Any computer and related peripheral equipment. This is unless it is only used at a regular business and owned or leased by the person operating the business,
- Any cellular telephone.
The issue with listed property is that they have a reduced amount of depreciation that you can take for the year.
Next, you will need to determine if you want to take Section 179 depreciation. This will allow you to immediately deduct the cost of certain types of property as an expense, rather than depreciating the property over a couple of years. This property is generally limited to tangible personal property such as equipment and vehicles. Buildings are not eligible for section 179 deductions. Depreciable property that is not eligible for a section 179 deduction is still deductible over a number of years through MACRS depreciation.
Additionally, the asset may qualify for some “bonus” first year depreciation. For this bonus depreciation, you do not need net income to take this deduction. This depreciation is limited based on the size of the business, nor capped at a certain dollar level. This deduction cannot be taken for property located outside of the US, tax-exempt use property, or tax-exempt financed property.
And, of course, you will also need to know the depreciable basis of the property. This is basically is what you paid for the asset plus any improvements, less any casualty losses or depreciation previously deducted, and the value of any land (if the asset is property).
Which Depreciation Method is Right for Your Business?
Now that you know all of that information, you will need to determine your depreciation method. Over the years, there have been several used, and the one you should use is based on when you purchased the item. If you bought it and placed it in service before 1981, you should have used the straight line or declining balance method, which pretty much means you either take the same amount of depreciation every year, or a very simple percentage taken every year on the remaining value of the equipment.
If you bought and placed it in service after 1980 and before 1987, you use the ACRS method, which stands for Accelerated Cost Recovery System. This means that you take a greater amount of depreciation at the beginning of the asset’s life. For everything purchased and placed in service after 1986, you would use the MACRS, or Modified Accelerated Cost Recovery System, method. The difference between ACRS and MACRS is that MACRS uses longer recovery period, which reduces the depreciation you can take on property.
Once you determined your depreciation method, you can look up the depreciation percentage to use to determine the amount of depreciation you should take for the year. If you have questions, contact an accountant who can walk you through your options.
Chris Peden, CPA, CMA, CFM has over 15 years in the corporate world helping companies meet their regulatory compliance requirements. He also assists small business owners with organizing and making sense of their finance information. You can reach him at firstname.lastname@example.org, or check out his blog at www.theaccountingscribe.com . In accordance with Circular 230 Treasury Department Regulations, we are required to advise you that any tax advice contained in this article may not be relied upon to avoid penalties under the Internal Revenue Code. If you are interested in a written opinion that can be relied upon to prevent the imposition of tax-related penalties, please contact the author.