Understanding Depreciation of Business Expenses

Business deductions are pretty straightforward in ideology- basically anything that you use for your business you deduct against your income. But in practice it starts to get more complicated because of depreciation. Basically, anything you buy for your business that has a longer useful life than one year should be depreciated. This can also benefit you when starting a business as it allows you to carry expenses into future years where your income may be higher.

Basics of understanding depreciation...

How long is the item depreciated for?

There are guidelines posted by the IRS for how long certain objects useful "life" are and you have to go by those guidelines. For example, computers or photo equipment are depreciated for five years. Yes everyone knows computers are unlikely to last five years- yet that is how long the IRS says the last so that is what you have to depreciate it over. Depreciation is a bit more complicated than that, because you actually have several choices of what to do with the items that are depreciable. Keep in mind that not every item is depreciable in all these ways, certain rules come into play and you it is advisable to do substantial research, the IRS information on depreciation is here, or hire a knowledgeable accountant, to take full advantage of the power of depreciation.

Method One: MACRS

The default method of depreciation that most preparers and software use, the "MACRS" method is an accelerated method to recover your depreciation. Using this system you would write off 20% the first year, then 32% the second year, 19.20% the third year, 11.52% the fourth and fifth years, and 5.76% the sixth year.

Method Two: ADS

You can choose an alternate system of depreciation, known as "ADS", and depreciate the computer over a seven year period starting with 10.71% the first year and going up to 19.13% the second year and then down again to 15.03% the third year and 12.25% from years four through seven, then 6.13% on the eighth year.

Method Three: Straight Line

Using the "straight line" method with the computer example would mean you get to write off 10% the first year of the cost of the computer against your income, then 20% each additional year for the next four years, then 10% again on the sixth year.

Method Four: Section 179 Expensing

You can expense the total purchase price of the computer against your current income by using section 179 of the tax code. To be able to expense the property purchased must meet certain requirements,  viewable here.

Method Five: Bonus Depreciation

Congress often passes laws about bonus depreciation amounts in attempts to stimulate the economy. Generally this gives an additional 50% depreciation amount to be taken in the first year an item is purchased and applies to many situations when the Section 179 deduction would not be available. Also, corporations can often elect to use this bonus depreciation as a general business credit rather than a deduction.

Navigating What is Best...

As you can probably now imagine, it can be quite complicated to determing which form of depreciation is best in each situation. And this is far more complicated when you examine the full lists of what property is depreciated over which time period and the full rules to deduct this. A good CPA certainly earns their money when depreciation comes into play as this can make a big difference on the after tax cashflow of a business.



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