Depreciation Basics: What is it & How Does it Work?
Depreciation is the process of allocating the cost of a long-term asset (such as equipment, vehicles, buildings, or machinery) over its useful life. Instead of deducting the full cost of an asset in the year it's purchased, depreciation allows businesses to spread that cost over several years. This reduces taxable income and provides businesses with an ongoing tax benefit.
Here are the basics of depreciation that business owners should understand:
What is Depreciation?
Depreciation is an accounting and tax concept that applies primarily to tangible assets used in a business. It represents the decline in value of an asset over time due to factors like wear and tear, obsolescence, or age. Businesses can deduct a portion of the asset's cost each year, rather than taking the full deduction in the year of purchase.
Common assets that are depreciated include:
Equipment (e.g., computers, machinery)
Vehicles
Buildings (although land is not depreciable)
Furniture & Fixtures
Improvements to business property (e.g., new roofs, HVAC systems)
Why Depreciate?
Tax Benefits: Depreciation reduces taxable income, meaning the business pays less in taxes. This is especially beneficial for businesses with significant capital expenditures.
Matching Expense to Revenue: Depreciation spreads the expense of an asset over its useful life, matching the cost with the revenue generated by that asset each year.
Cash Flow: Depreciation is a non-cash expense, meaning it doesn't directly affect cash flow, but it reduces taxable income, potentially freeing up cash that can be reinvested in the business.
Accurately Reflects Asset Value: Depreciation reflects the actual reduction in value of an asset over time due to wear and tear, obsolescence, or usage. It helps present a more accurate financial picture for both tax reporting and financial statements, giving you a clearer understanding of the asset’s remaining value, helping businesses track their net worth more accurately.
How Depreciation Works
When a business purchases a depreciable asset, it cannot immediately deduct the entire cost on its tax return (unless specific exceptions like Section 179 or Bonus Depreciation apply). Instead, the business must depreciate the asset over time.
Here is the basic process of calculating depreciation:
Determine the Asset’s Cost: This includes the purchase price, sales tax, installation costs, shipping, and any other costs related to getting the asset ready for use. Note that for real estate (commercial or residential), you need to separate out the land from the building. The building portion is depreciable, while the land is not.
Estimate the Useful Life: The IRS assigns a useful life for each type of asset. This is the period over which the asset will be depreciated. For example:
Vehicles: 5 years
Office Furniture: 7 years
Residential Real Estate: 27.5 years
Commercial Property: 39 years
Choose a Depreciation Method: The IRS allows several methods for calculating depreciation, with the Modified Accelerated Cost Recovery System (MACRS) being the most common method for tax purposes.
Depreciation Methods
The two most common depreciation methods are:
1. Straight-Line Depreciation
This method spreads the depreciation expense evenly over the asset’s useful life.
Formula: Annual Depreciation Expense = (Cost of Asset – Salvage Value) / Useful Life
Example: If you buy a computer for $2,000, with a 5-year useful life and an estimated salvage value of $200, the depreciation expense would be: (2,000−200) / 5 = 360 per year
The same amount ($360) would be deducted each year.
2. Accelerated Depreciation (MACRS)
Under MACRS (Modified Accelerated Cost Recovery System), a larger portion of the asset’s cost is deducted in the earlier years of the asset’s useful life, and smaller amounts in later years.
The IRS assigns specific recovery periods and depreciation schedules for different types of property. For example, most equipment and machinery have a 5–7-year life under MACRS.
Example: If you use the 5-year MACRS schedule for an asset purchased for $2,000, you’d have different depreciation deductions in each year (e.g., 20% in the first year, 32% in the second year, etc.), allowing for larger deductions early on.
Types of Depreciable Assets
The IRS categorizes assets into different classes with different useful lives for depreciation purposes. Here are some common examples:
5-year property: Automobiles, computers, office equipment, certain furniture and fixtures.
7-year property: Office furniture, fixtures, and equipment.
27.5-year property: Residential real estate.
39-year property: Non-residential commercial real estate (e.g., office buildings, warehouses).
Bonus Depreciation
Bonus depreciation allows businesses to take an additional first-year deduction on qualifying property, including new and used assets. This can be a significant benefit if you want a bigger deduction in the year of purchase.
100% Bonus Depreciation: For property placed in service from September 27, 2017, through 2022, businesses could deduct 100% of the cost in the first year.
Phase-Down Schedule: Starting in 2023, the percentage allowed for bonus depreciation begins to decrease:
80% for property placed in service in 2023
60% for property placed in service in 2024
40% for property placed in service in 2025
20% for property placed in service in 2026
After 2026, bonus depreciation is no longer available unless extended by future legislation.
Example: For property placed in service in 2024, businesses can deduct 60% of the asset’s cost in the first year, with the remaining amount depreciated in future years.
Important: Bonus depreciation applies to assets with a useful life of 20 years or less, including most vehicles and equipment.
Section 179 Deduction
Section 179 allows businesses to expense the full cost of certain qualifying property (up to a limit) in the year it’s purchased, rather than depreciating it over time. This applies to both new and used property, including equipment, machinery, and vehicles.
2024 Section 179 limit: The limit for Section 179 deductions is $1,220,000 for qualifying assets, but this is phased out if total equipment purchases exceed $3,050,000.
Example: If you buy a machine for $100,000 and qualify for Section 179, you can deduct the full $100,000 in the year of purchase, rather than depreciating it over several years.
For SUVs and trucks, Section 179 has special rules. If the vehicle has a gross vehicle weight over 6,000 pounds, you may be able to deduct up to $30,500 in the first year (2024 limit), with additional depreciation available in subsequent years.
Important Considerations for Depreciation
Business Use Percentage: If an asset is used for both business and personal purposes, you can only depreciate the portion used for business. For example, if you use a vehicle 70% of the time for business, you can only depreciate 70% of the vehicle’s cost.
Depreciation Recapture: Depreciation lowers your basis in the asset. That means when you sell a depreciated asset, the IRS may require you to "recapture" some of the depreciation as income, particularly if the asset was sold for more than its depreciated value. For example, if you purchase an asset for $40,000, then take $10,000 of depreciation, your basis is now $30,000. If you sell that asset for $35,000 you will have a $5,000 taxable gain (depreciation recapture).
Asset Disposition: If you dispose of or sell a depreciated asset before the end of its useful life, you may need to adjust your depreciation deductions.
Depreciation for Tax Reporting
Businesses must report depreciation on IRS Form 4562 (Depreciation and Amortization) when filing taxes. This form lists assets and their depreciation schedules, and it is used to claim deductions for both regular depreciation and Section 179.
The Bottom Line
Depreciation is an essential tool for reducing taxable income and managing the cost of long-term assets. By understanding the various depreciation methods—such as straight-line, MACRS, Section 179, and bonus depreciation—business owners can optimize their tax savings and manage their asset costs effectively. However, because depreciation rules can be complex, it’s always a good idea to consult with a tax professional to ensure you are applying the most advantageous methods for your business.