How to calculate depreciation

When you make a pricey purchase, whether that be for a home or business, certain tax rules may make it possible for you to deduct the depreciation of these items on your tax return. By spreading the total cost of your asset purchases over its entire estimated lifespan, you may be able to reduce your tax liability. Read on to learn more about the importance of depreciation, the different ways you can calculate depreciation, and how to keep more of your money in your pocket during tax season.

The importance of depreciation 

Depreciating assets should be one of your top priorities as you are preparing to file your tax returns. When you depreciate your assets, you can exercise more control over your finances. When you take advantage of the deductions that come with depreciation, you can keep the total expense off of your accounting books and spread it out over several years. This could help reduce your tax liability and allow you to hang onto more of your hard-earned money.

What is depreciation?

Depreciation is something you will use when focusing on your business' accounting responsibilities. You depreciate the cost of an asset for the length of its useful life. The "useful life" of an item depends on how long it will generate revenue and remain in service. When you purchase assets for your business, they can be deducted as business expenses on your federal tax return. However, according to Instructions for Form 4562, the United States Internal Revenue Service (IRS) requires you to spread out the total cost of these assets, including the deduction on your tax return. 

The exact amount of depreciation can vary widely depending on the total cost of the item in question. For example, if you purchased a desktop computer for your company that cost $1,000 and the average life of the computer is 10 years, it will decrease in value by 10% annually. You can think of depreciation as a financial representation of how much your asset value is lost each year.

The exact amount of depreciation can vary widely depending on the total cost of the item in question. For example, if you purchased a desktop computer for your company that cost $1,000 and the average life of the computer is 10 years, it will decrease in value by 10% annually. You can think of depreciation as a financial representation of how much your asset value is lost each year.

An overview of depreciation in business 

Startup costs and ongoing business expenses can be costly. By taking advantage of depreciation, you can match depreciation expenses within the same reporting by spreading out the cost over the length of the asset's useful life.

In doing so, you can move the cost of your assets to your income statement instead of keeping it on your balance sheet. It should be recorded as a debit that will increase your asset account and a credit to increase accounts payable or reduced cash flow on your balance sheets. However, it is important to note that either one will not affect your income statement.

Your accountant will need to book the depreciation for any capitalized assets that were not yet fully depreciated. Depending on the type of asset and your specific tax situation, you could report the depreciation as a credit on your balance sheet or a debit on your income statement. It should be noted that while structures, buildings, vehicles, machinery, and other assets can be depreciated, you cannot depreciate the value of purchased land.
 

Accounting depreciation 

Depreciation is not considered a cash charge. This is because depreciation does not represent your business' actual cash outflow. Even if you purchase the asset in full at the time of purchase, the expense should be reported on your financial records incrementally to take advantage of the tax benefits.

Depreciation of the assets will reduce your business' earnings which can help reduce the amount you owe in taxes. According to the Generally Accepted Accounting Principles (GAAP), the matching principle states that expenses should be matched to the period where the related revenue is generated. This ensures the cost of the asset is tied to its benefit throughout its life. Essentially, the incremental expenses are included for each year the assets help your business generate revenue.

The amount depreciated annually is recorded as a percentage and is known as a "depreciation rate.” Here is an example: Let's say your business had $100,000 of depreciation over the course of the asset's anticipated use life. If the annual depreciation were $10,000, the depreciation rate would be set at 10% annually.

Threshold amounts 

Threshold amounts can be thought of as the maximum dollar amount over which an asset will depreciate. These are most frequently used to depreciate property, plant, and equipment (PP&E) or fixed assets. Larger companies may be more willing to set $5,000, $10,000, or an even higher threshold and expense asset purchases immediately whereas smaller businesses may set lower thresholds when depreciating assets.

Taxes and your depreciation schedule

Businesses should be taking advantage of depreciation for accounting and tax purposes. If you are going to be depreciating assets, the IRS requires you to spread them out over time. However, certain circumstances can allow you to take the entire deduction within the first year according to Section 179 of the U.S. tax code. 
 

Salvage value

You can determine how many years over which your assets should be depreciated for tax reasons according to the most recent IRS Depreciation Schedule. The salvage value of an asset determines what you will receive for the asset once it is no longer of use to your business.

Accumulated depreciation

With your general ledger, you may use a contra account. This type of account is designed to represent a decrease in the value of the account it is paired with. Your business may be using a contra account to reduce the value of another account that is tied to your business. The balance of your contra account is the opposite of its associated account. For example, if the debit is the natural balance as indicated in your related account, your contra account will record it as a credit. 

Accumulated depreciation is a type of contra-asset account. The natural balance of the accumulated depreciation acts as a credit, which reduces the asset's overall value. You can think of accumulated depreciation as the total accumulated depreciation up until a certain point in the life of the asset.

Carrying value

Carrying value refers to the total accumulated depreciation and the net of your asset account. In contrast, the salvage value determines the carrying value that remains on your record books once the asset is disposed of and the total value of depreciation is accounted for.

Depreciation methods

There are multiple ways you can go about calculating the cumulative depreciation of business assets. The most notable include:

• Straight-line depreciation 
• Declining balance depreciation
• Double declining balance depreciation
• Sum-of-the-year digits depreciation

You, or your accountant or tax adviser, can use these methods to calculate the depreciation of your business assets and save your company from undue tax liability.

Straight-line depreciation

Small business owners often use the straight-line depreciation method when they are doing their taxes solo. To determine the depreciation of your assets using the straight-line method, you should take the asset cost and deduct the salvage value. Then, divide that figure by the anticipated useful life of the asset.

For example, let's say you bought a heavy piece of machinery for $15,000 and the salvage value of the equipment is $1,000. You would take $15,000 and subtract $1,000. This would give you a sum of $14,000. If the machinery has a useful life of 15 years, you would divide 14,000 by 15, to get a sum of $933.33. This means you could deduct $933.33 every year for the next 15 years of the equipment's useful life.

Declining balance 

Instead of starting with the salvage value, when you use the declining balance method, you will begin calculating the depreciation of your assets by examining the asset's book value. Most assets have a carrying value that is higher the year you purchased it and declines over time. This means your initial depreciation expense in earlier years will be higher. Here is the declining balance method depreciation formula:

Declining balance depreciation = Book value x (1/useful life)

Let's look at an example. Say you bought furniture for your consulting business that cost $5,000. If the furniture has a useful life of 10 years, in year one, the depreciation would be figured out by multiplying $5,000 by 1/10. This would give you a sum of $500.

In the second year, you would obtain your depreciation value by taking the total cost of $5,000, subtracting your $500 deduction from year one, and multiplying that figure by 1/10. This would give you a depreciation value of $450. 

By year three, you would take the total cost of your furniture purchase at $5,000 and deduct the depreciated values from years one and two, which were $500 and $450, respectively. You would then multiply that sum by 1/10. This would give you a depreciation value of $405 for year three.

Double declining balance method

Many business owners turned to the double declining balance method as a way of recovering more of the early value of a specific method. To use the double declining balance method, you should:

1. Double the amount of your depreciation under the straight-line depreciation method
2. Multiply that by the value of the specified asset at the start of the year
3. Subtract that by the value of the asset in year one
4. Repeat steps 1 and 2 for subsequent years

The double-declining balance depreciation formula is as follows:

2 x straight-line depreciation rate x book value = declining balance per year

Let's look at an example of your deduction using the double-declining balance depreciation method. You bought a company vehicle for $40,000 which depreciates over 10 years. The straight-line depreciation rate is 10%. To determine the first-year depreciation deduction, you would multiply 2 by .10 to get 0.2 and multiply 0.2 by $40,000 to get $8,000. This means you can deduct $8,000 from the vehicle's value within the first year.

Sum-of-the-year digits depreciation

To get a more even distribution over time while recovering more of your business assets value upfront, use the sum-of-the-year digits method (SYD). To do this, you should:

1. Add the digits of the asset's useful life to get the SYD
2. Divide the remaining lifespan by the SYD
3. Subtract the total salvage value from the cost of the asset
4. Multiply these two figures

The sum-of-the-year digits method formula is as follows:
(Remaining lifespan / SYD) x (asset cost - salvage value) = SYD

For example, if you bought a new networking system for your company at a rate of $10,000, with a salvage value of $500 and a 10-year useful life, you will begin by adding up the years of the useful life to get 55. then, you would use this formula: (10 / 55) x (10,000 - 500) = $1,727.27 to obtain the first-year deduction.

Vehicle depreciation

Many businesses rely on company vehicles to generate income and revenue. Small business owners often look for opportunities to leverage tax deductions they may be entitled to reduce liability. Vehicle tax depreciation may or may not be something you are familiar with. If your business owns one or more vehicles, you may qualify for tax deductions. However, before you attempt to include these deductions on your tax return, it is important to understand how vehicle depreciation works.

You can deduct vehicle depreciation from your taxes

You may qualify for tax depreciation on your vehicle if you use your vehicle for business purposes. A portion of the cost of the vehicle will be deducted annually until you have fully recovered the cost of the vehicle. Requirements that must be met for vehicle depreciation under Topic No. 704 include:

• You cannot use the vehicle as a car rental service
• You can only use the vehicle within the U.S.
• You must be the owner of the vehicle to claim it as a tax deduction
• You must use the vehicle for work-related purposes at a minimum of 50% of the time

When using a vehicle entirely for business reasons, the entire cost of operation and ownership could be deducted. However, if you also use your vehicle for personal use, you can only deduct the depreciation of the vehicle for business use.

Five-year vehicle depreciation

The IRS states that taxpayers should depreciate the cost of business vehicles over six years since vehicles are “generally treated as placed in service in the middle of the year, and you claim depreciation for one-half of both the first year and the sixth year.” 

However, according to the Modified Accelerated Cost Recovery System (MACRS), the standard depreciation for a vehicle would be five years since vehicles are considered five-year assets. The maximum amount that you can deduct for your vehicle depreciation will depend on the make and model of the vehicle, the year it was put into service, and other factors.

Calculating vehicle depreciation on your taxes

There are a couple of different ways you can calculate the depreciation of your vehicle during tax season. These include using the declining balance method or MACRS, or through straight-line depreciation.

How the Modified Accelerated Cost Recovery System (MACRS) method works 

Vehicle depreciation for any vehicles put into service after 1986 that are used at least 50% of the time for business reasons should be determined using the modified accelerated cost recovery system (MACRS) method. some of the different details you will need to consider include:

• What percentage of your vehicle is used for business reasons
• The total cost of the vehicle, including taxes, costs, fees, and registration
• The date the vehicle was put into service

You can use IRS Form 4562 to determine the depreciation of your vehicle once you have this information. Here is a basic example:

Your business buys a car that was first introduced for purchase on Jan. 1, 2023. The purchase price and additional fees totaled $50,000. This is known as the “basis.” You use the vehicle for business purposes 75% of the time. Using the MACRS method, the basis used for depreciation would be $37,500. At a 200% declining rate, you would be entitled to a 40% depreciation rate. By deducting 40% of your $37,500 basis, your deduction after vehicle depreciation would be $15,000.

Straight-line depreciation

Alternatively, you may find it necessary to use the straight-line depreciation method. Most often, the straight-line depreciation method would need to be used if you originally used the standard mileage rate the year the car was put in service but then changed an actual expense method the following year before the vehicle reached its full depreciation value. 

You may also need to use the straight-line depreciation method if your business uses the vehicle less than 50% of the time. You will need to divide the vehicle basis evenly throughout the anticipated useful life of the vehicle to determine your deduction.
 

How Section 179 deductions work for automobiles

According to 26 U.S. Code § 179, you have the right to recover part or all of the cost of certain types of qualifying property. You may qualify for Section 179 if you use your vehicle for business purposes at least 50% of the time. If you use the vehicle at least 50% of the time for work purposes but less than 100% of the time, you may need to calculate the allowable deduction.

The standard mileage rate for 2024

The IRS recently announced that the business standard mileage rate for 2024 is $.67 per mile. This is a 1.5 cent increase from the 65.5 cent per mile rate that applied during 2023. Instead of determining the actual deductible expenses, you can use the standard mileage rates if it will save your business money.

How to calculate depreciation FAQs

We understand how confusing taxes and depreciation can be. You may be hesitant to calculate depreciation on your own. However, once you understand how business depreciation and taxes work, you may feel more confident in taking advantage of the deductions you are entitled to. Review some of the most common questions regarding business depreciation and assets to get the answers you need when you need them most. 

Why are assets depreciated over time?

Assets depreciate over time. The newer your assets are, the more valuable they will be. Certain assets lose value over time. Depreciation measures how much value is lost over several years. 

Many factors, including wear and tear, inflation, and the availability of newer product models all determine how quickly your assets will depreciate. Instead of writing off the total depreciation in one year, it is more than likely in your best interest to depreciate the assets of value over several years so you can report higher net earnings the year of your purchase.

How do businesses determine salvage value?

Businesses will determine the salvage value of certain types of assets by taking a percentage estimate of the asset value when you can no longer use it. Alternative salvage value options include hiring a professional appraiser or reviewing the historical value of similar types of assets.

What is depreciation recapture?

Depreciation recapture is described by 26 U.S. Code § 1250. It requires individuals or businesses that sell assets for profit that have previously depreciated to report the sale of these assets as income. Essentially, the depreciation amount will be subtracted from the price the asset was sold at to determine the transaction gains. Depreciation recapture is often seen in real estate transactions which often increase in value over time.

How does depreciation differ from amortization?

According to 26 CFR 1.197-2, amortization involves the depreciation of intangible assets such as patents, trademarks, or intellectual property. Conversely, depreciation involves the loss and value of property or physical assets, such as real estate, vehicles, collectibles, or machinery.

Understanding depreciation and making accurate calculations is critical  

When you spread the cost of your physical assets out over a period of time through depreciation, the tax advantages are undeniable. With several potential depreciation calculation methods to choose from, you can run the numbers and select the one that will best meet your needs. Although tax depreciation can be confusing, with the right resources and tools, you can cut your time spent working on accounting and spend more of your time focused on your business or family.