Whether you’re a new entrepreneur or have been running your business for a while, depreciation might be an unfamiliar or confusing expense category. However, it’s crucial to become acquainted with it because depreciation can offer valuable income tax deductions, potentially saving you thousands of dollars annually, and providing you with the opportunity to reinvest in your business.
What Is Depreciation?
Depreciation opens up the opportunity to deduct the expenses of significant business assets over the duration that you utilize them, rather than deducting the entire cost in just one year.
To illustrate, imagine purchasing a MacBook Pro for your business at a cost of $2,400. It’s safe to assume that this MacBook will last longer than a single year. So instead of deducting the full cost in the year of purchase, you have the flexibility to spread out the deduction over the years that you will be using the MacBook in your business.
How to Calculate Depreciation?
When it comes to applying depreciation to your business, there are generally two methods to consider: Tax depreciation and book depreciation. Tax depreciation is determined by legal regulations, while book depreciation can be customized for your own accounting needs.
About Tax Depreciation
Tax depreciation aligns the cost of an asset with the duration it will be used in your business. This allows you to take advantage of the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. With MACRS, you can claim a larger deduction in the initial years of the asset’s useful life, followed by smaller deductions later on.
The useful life of an asset depends on its class, and for small businesses, the commonly used classes are the five-year property (such as computers, office equipment, cars, and light trucks) and seven-year property (including office furniture and fixtures). To simplify the calculation of MACRS depreciation, IRS Publication 946 provides detailed tables tailored to different asset types. However, it’s advisable to rely on software or a tax preparer for these calculations, as MACRS depreciation is more complex than straight-line depreciation.
About Book Depreciation
Book depreciation serves as a valuable tool to align the expense of an asset with the revenue it generates throughout its lifespan. By adopting the straight-line method, a popular approach for book depreciation, you can evenly divide the total cost of the asset by its useful life. This calculation allows you to determine the annual depreciation amount until the asset reaches the end of its useful life.
To illustrate, let’s say you anticipate utilizing the $2,400 MacBook Pro for five years. In terms of book purposes, you would record a depreciation expense of $480 per year ($2,400 รท 5). This systematic approach ensures that your financial records accurately reflect the gradual decline in the value of your assets over time.
Which Depreciation Method Should I Choose?
Many businesses choose to calculate depreciation using both the straight-line method for their internal financial reporting and the MACRS method for their tax returns. However, unless there is a requirement to use a different method for bookkeeping than for taxes, it is often more convenient and efficient to track depreciation using the same method that will be used on the tax return. This ensures consistency and simplifies the overall depreciation process for the business.
But wait, what about Section 179? How does it factor into all of this?
Section 179 is a game-changer for maximizing business expenditures. It allows you to expense the full cost of assets in the year they’re placed in service, providing a shortcut to big tax deductions. For example, you can deduct the full cost of a MacBook Pro in the year you start using it for your business. However, remember that the deduction is only available for assets in use. There’s a cap of $1,080,000 per year, but if your deduction doesn’t exceed your taxable business income, you can carry forward any leftover deduction. Just be aware that the deduction starts to phase out if you purchase more than $2.7 million in property during the year. Don’t miss out on maximizing your business expenditures with Section 179!
How Can You Claim Depreciation for Your Business Expenditures?
To claim depreciation and a Section 179 expense, you must complete Form 4562 and attach it to your return.
Looking for a simpler solution?
While we try our best to simplify complex topics like depreciation and the Section 179 deduction, even seasoned tax professionals can struggle to remember all the details. But fear not! There’s a simple solution to get a tax break when you purchase certain assets: the de minimis safe harbor election.
Now, the name might sound intimidating, but it’s actually quite straightforward. With the de minimis safe harbor election, you can immediately write off the cost of specific assets up to $2,500 (and even more if you have audited financial statements prepared by a CPA).
This may sound similar to the Section 179 deduction, but the de minimis safe harbor election comes with less bureaucratic red tape. One major advantage is that there’s no limit on the amount you can deduct, as the $2,500 limit applies per asset.
For example, let’s say you bought five MacBook Pros at $2,400 each. Instead of reporting each MacBook on Form 4562 and worrying about carrying the deduction forward if your business income isn’t sufficient to absorb the full deduction, you can simply deduct the full $12,000 as equipment expense.
Taking advantage of the de minimis safe harbor election is a breeze, but there are a few important rules you need to follow.
1. Establish a written expensing policy before the start of the year in which you plan to utilize the de minimis safe harbor rule for asset write-offs.
Creating this policy is as simple as drafting a document that states:
“For tax years starting in 2021 and beyond, {BUSINESS NAME} chooses to classify property with a cost of $2,500 or less, including items with a useful life of 12 months or less, as an expense for both bookkeeping and income tax purposes. It is our intention that this election aligns with the IRS Section 1.263(a)-1(f) de minimis safe harbor election.”
Print, sign, and date this document, and keep it alongside your business’s organizational records.
2. Ensure that you make the de minimis safe harbor election on your year-end tax return.
Most tax software simplifies this process by providing a checkbox option, but remember that the election needs to be made annually and selected each year.
Many small business owners tend to shy away from the topic of “depreciation,” but it is actually something that can be highly beneficial for them. While the calculations may seem complex, they can significantly increase tax savings in the years when your business needs it the most. If you find the calculations daunting, you can always consider hiring a tax professional to handle them for you.