How to calculate depreciation (2023)

When your company purchases an asset (your company's physical property), you can deduct the cost of that asset as a business expense. However, tax regulations say you must spread the cost of that asset over its estimated useful life. This type of long-term discount is called amortization.

Depreciation is defined as the value of a business asset over its useful life. How depreciation is calculated determines the amount of a depreciation deduction you can take in any given year. Therefore, it is important to understand the methods of calculating depreciation.

staple foods

  • Depreciation is a method of spreading the depreciation of a long-term business asset over several years.
  • The basic way to calculate depreciation is to consider the cost of the asset minus any residual value over its useful life.
  • Depreciation is treated differently for accounting and tax purposes, but the basic calculation is the same.
  • Taking depreciation expenses each year is one way to reduce your business tax bill.

How does depreciation work?

When your company purchases real estate for long-term use, you can deduct the cost of the real estate by spreading it over several years using a process calleddevaluation. The Internal Revenue Service (IRS) calls this type of property (such as vehicles, machinery, equipment, and furniture)capital bens.

Let's say you bought computer equipment for your company at a cost of $8,000. The average computer lasts 10 years, so its value depreciates by 10% each year. You can get an $800 depreciation deduction each year on your business tax return.

To use

Depreciation is simply an accounting method of showing the cost of using an asset over time. It has nothing to do with how you purchased the item, its actual physical condition, or the number of years it has actually been used in your business. For example, if you buy or lease a car for your business, you can depreciate it depending ontype of lease.

Which assets can be depreciated?

The types of business assets that you can depreciate are called equity assets (referred to as "property" by the IRS). These items include buildings, improvements to your property, vehicles, and all types of equipment and furniture.

You can depreciate assets used by your business for income generating activities. The asset must have a determinable useful life and must last for more than one year.

Cannot be depreciated:

  • Property that must be sold within a year (such as office supplies)
  • Equipment used to create capital improvements
  • TRUEintangible assetssuch as computer software, patents or trademarks

You also cannot depreciate land because it does not reduce its value.

How to calculate depreciation

To calculate depreciation, you need to know:

  • The cost of the asset (asset base), including asset purchase, freight, installation, and training costs
  • The useful life of the asset (also called the payback period)
  • Residual value at the end of its useful life

You can find the useful life (called the "payback period" for tax purposes) of specific business assets atProblem 946 Depreciable real estate.

Depreciation is calculated annually for tax purposes. The most common depreciation is called straight-line depreciation, considering the same amount of depreciation in each year of the good's useful life.

For example, the first year calculation for an asset that costs $15,000 with a salvage value of $1,000 and a useful life of 10 years would be $15,000 minus $1,000 divided by 10 years equals $1,400.

Fixed assets must be put into operation (installation and use) in the first year in which depreciation is calculated.

depreciation methods

There are several methods for calculating depreciation. For each method, you should know:

  • Customized basis (full cost)
  • Residual value, if any.
  • Lifetime/payback period

Fixed depreciation.The method described above is called straight-line depreciation, where the depreciation deduction amount is the same for each year of the asset's life.

Decreasing balance.This method includes an “accelerator”, whereby the asset is further depreciated at the beginning of its useful life. It is used with cars, for example, as a new car depreciates faster than an old one. With this method, the depreciation expense is reduced each year of the asset's useful life. There are several types of declining balance, including a 200% method and a 150% method.

Depreciation based on usage.Some assets contribute more to income by different amounts from year to year. The depreciation cost of these assets can be higher or lower in some years. In these cases, each year's depreciation expense is based on the units of production or units of production generated by the asset. An example of this would be the depreciation of a machine that makes car parts.

To use

The IRS requires companies to use theModified Accelerated Cost Recovery System (MACRS)for a quick return. Most companies use the general depreciation system (GDS) in MACRS to calculate declining balance and straight-line depreciation.

When the asset reaches its useful life

When an asset has been fully depreciated, it is considered "off the books" of the company. This does not mean that the asset is no longer useful, but rather that the company cannot incur further depreciation expense for that asset. The residual value remains on the books until the item is sold or disposed of.

Additional Special Depreciation

Favorable depreciation options are available to speed up the depreciation process so you can earn more tax credits faster. There are two types:

  • ONEDeduction from article 179.ºfor the purchase of commercial vehicles and equipment
  • An additionaldepreciation titlein the first year you buy and use the asset

These special types of additional deductions come with limits and qualifications, so check with your accountant to see if you qualify.

Report the depreciation on your income tax return

To calculate depreciation deductions for your tax return you will need to useIRS Form 4562. You must also use this form to claim a 179 discount or special bonus depreciation. Before submitting the form, you will need to separate the assets

  • Those you bought during the term and those you bought in previous years
  • Classification of the property by years of recovery period
  • The depreciation system (MACRS is the most common)

Vehicle depreciation is indicated in Section B of Part V of the form. You then add that amount to your business income tax form, based on yourtype of business.

To use

Depreciation calculations are complicated and there are many limitations and tax requirements to comply with. Keep good records of your business assets and ask your accountant for help.

Frequently Asked Questions (FAQ)

What is bonus depreciation?

Additional depreciation is a special type of accelerated depreciation that you can use to write off most of the cost of depreciable business assets in the year they were first put into service (created for use). This 100% discount applies to assets with a payback period of 20 years or less, including machinery, equipment and furniture. You can take it along with other depreciation.

How is depreciation recorded?

You can record depreciation in your small business accounting system using business accounting software. Start by entering basic information about each asset: cost, salvage value (residual value), and estimated useful life.

At the end of each year, depreciation expenses for the year and the increase in accumulated depreciation are recorded. The difference between these two values ​​is the book value of the asset. Your software program adds information about all assets to the "Details" side of your company's balance sheet. Each asset type is listed separately, net of total accumulated depreciation, against the net worth of all assets.

What is depreciation recapture?

When you sell or dispose of business assets that you have depreciated using MACRS, any gain is generally recaptured as ordinary income up to the allowable depreciation amount for the property.

A common example is an asset for which you received a Section 179 deduction. In this case, the amount you must include as income on your tax return is the difference between the deduction amount you claimed using the Section 179 deduction and the discount amount allowed without taking into account this special discount.

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