Do you know how to calculate small business depreciation? It’s an important skill to have. After all, small businesses can benefit significantly from claiming depreciation on their assets at business tax time. Besides that, the IRS expects you to fill out the tax form accurately. So, it’s important to get this right. However, the rules for depreciation can be difficult to understand. Here’s what you need to know about depreciation and how to make the calculations.
What is Depreciation?
Depreciation refers to the fact that many of your business assets will become less valuable over the years. For example, a company car begins to lose value as soon as you drive it out of the car dealership. What’s more, it continues to become worth less with every year that goes by.
Fortunately, the IRS provides a way to account for these losses in value. Even better, you can decrease the amount of taxes you pay if you know how to calculate small business depreciation. Once you do, you can take part of this decreasing value as a deduction each year until the item has passed its useful life. Then, with all your deductions and credits, you can come out better on your taxes.
To calculate the depreciation of any item, you need to know the approximate time you will be able to use it in your business. You also need the cost of the item, along with sales tax and shipping. Finally, you must know the salvage value, or in other words, what you can sell it for when it is no longer useful in your business. You will need to know about the depreciation of your assets when you are budgeting or planning the future of your business.
Types of Depreciation
Before you can know how to calculate small business depreciation, you need to understand the different types of depreciation. Each type has its own rules, advantages, and disadvantages. You need to know which depreciation method is the right for the asset and your company. Remember, the tax credits and deductions can make a large difference in how much tax you pay. Consider each of these methods before you begin the calculation.
The straight-line method is the easiest way to calculate how much to deduct from your taxes. In this type, you assume that the asset will depreciate the same amount each year.
Double-Declining Balance Depreciation
It makes sense to choose a double-declining balance method of depreciation for assets that decline in value faster during their early years of use. For example, a new vehicle loses value very quickly when you first buy it. This method allows you to account for that quicker loss in value.
Sum-of-the-years-digits might be the depreciation method to use when you have assets that either lose value quickly or increase your business’s productivity during the first years of its life. However, before you use this method of depreciation, consider whether you want depreciation to affect your taxable income. This method will make you show lower profits at first and then higher profits in later years.
Units of Production Depreciation
Suppose your business manufactures products. In that case, units of production depreciation might be the most logical choice. It allows you to depreciate your manufacturing equipment by how many hours it has been used or how many units it produces.
Modified Accelerated Cost Recovery System
Modified accelerated cost recovery system (MARCS) is the system used by the IRS for depreciation. Because of the MARCS rules, you must depreciate assets to an asset class before calculating the depreciation. You use the accelerated depreciation method to make a record of the depreciation using the straight-line or double-declining balance depreciation method.
In a few specific instances, you can take advantage of bonus depreciation. This is an incentive from the IRS that allows you to deduct a larger portion of the price of certain assets. The first year’s bonus depreciation is 100 percent. If you choose, you can take 50 percent depreciation in that first year and depreciate the rest over its useful life.
The main thing to remember is that most assets can’t be depreciated in this way. So, be sure your item is on the IRS list and that you also meet the other requirements for bonus depreciation.
What Assets Can You Depreciate?
Before you think about how to calculate small business depreciation, you need to know what assets you can depreciate. The rules here are relatively simple. You can depreciate an asset if it is something that:
- You own
- You use to produce income or need to run your business
- Has a useful life that you can determine
- You expect to last more than a year
For tax purposes, an asset must meet each of these criteria to be depreciated. So, even if your asset qualifies based on one of these four requirements, it can’t be depreciated if it doesn’t meet the other three.
How to Calculate Depreciation
Knowing how to calculate small business depreciation is an important skill to have. Each method figures the depreciation differently. Even if you have an accountant to prepare your taxes, you will want to consider which method would be best for your business. You will also need to track the variables that the accountant will use to make the calculations.
On the other hand, if you prepare your own taxes, you will need to know this subject inside and out. It will be useful for tax preparation and as you make business decisions and investments in your company.
Calculations For Depreciation Methods
Remember that you need some initial information before you start calculating depreciation. If you know the total original cost of the item and its salvage value, you can then calculate its useful life.
Straight-line depreciation spreads an asset’s loss of value evenly over the years of its useful life. This is an easy calculation. You simply subtract the salvage value from the original cost of the asset to get the useful life.
Asset Cost – salvage value = years of usefulness
Double-declining balance depreciation allows you to take more depreciation in the first year you buy it. Basically, the idea is that you take twice the straight-line depreciation in the first year. After that, you start with the book value of the asset, or the amount of value after the first year’s depreciation.
To do this calculation, you use two formulas. You start with the straight-line depreciation and multiply it by 2. Then, multiply the answer by the book value at the start of the year. Now, you have written off a part of the loss. The remaining value is the new book value. Multiply your first answer by the book value when the year began.
The first year: (2x straight-line depreciation rate) x value in first year = depreciation value to deduct from your taxes
Subsequent years: (2 x straight-line depreciation rate) x current book value = this year’s depreciation amount
Sum-of-the-years-digit depreciation (SYD) – This depreciation method also allows you to take more depreciation in the first years of its useful life. However, this option spreads the amount more evenly over the years than the double-declining balance depreciation method.
Calculate the SYD by first looking at the digits of the item’s expected useful life So, if the item had a useful life of 7 years, you would add up the digits like the following: 1+2+3+4+5+6+7 = 28
To get the rate of depreciation: Remaining years the item will be useful divided by the SYD.
Later years’ depreciation:(remaining years of usefulness expected/SYD) x (asset cost – salvage value) = depreciation
Units of Production depreciation works well for manufacturers and others who make products to sell. In this type of depreciation, you use the amount of work a piece of equipment completes over the year to find the depreciation for each year.
The formula goes like this:
(asset cost – salvage value)/ units produced during its useful life = depreciation amount.
MARCS – This depreciation method is used by the IRS, and it can be very complex. That’s why you need to discuss the subject of depreciation with your accountant, if possible. If you have accounting software, such as QuickBooks, it should be able to handle the depreciation as long as you input accurate information about your business and assets.
Additional Frequently Asked Questions
What is an Asset?
An asset is something that has monetary value for your business. It is something you own or control. In addition, an asset must be something that is expected to give you benefits in the future.
Current assets are liquid assets or assets that you can convert to cash easily, like inventory and short-term deposits. You can’t take depreciation on current assets. Fixed and non-current assets are long-term assets that you can’t quickly exchange for cash. These can be depreciated over time.
What Kind of Assets Can You Depreciate?
Many kinds of fixed assets can be depreciated. Consider the following examples of assets you can depreciate:.
- Cars and trucks
- Office equipment
- Furniture for your office
- Patents and copyrights
All of these assets must be used in the business with the aim of producing something, whether it is a service or a product. You must also own it, be able to know its useful life, and it must be likely to last more than a year.
When you hear the term “depreciation expense,” it refers to the current cost of the asset after it has been depreciated for a period. The depreciation expense reveals how much of the asset your company used up during that time.
What is the Accumulated Depreciation of an Asset?
The accumulated depreciation is defined as the total of all the depreciation expense you have allotted for the asset since you put it into use. This accumulated depreciation shows up on your balance sheet as a reduction from your fixed assets.
What is a Depreciation Schedule?
You can stay informed about the expected loss in value of your assets by making a depreciation schedule. This is a document that keeps track of that loss over the course of its useful life. With it, you not only know what the depreciation is for this year but also see what it will be in the future years that you use it.
What do you include in the depreciation schedule? You will need to describe the asset in enough detail that you can look at your document and determine exactly which item is listed in any line. You also need details like when you purchased it and its price, including sales tax and shipping. Plus, you need to know the salvage value, such as what a salvage yard would pay you for it.
The table should include the asset’s projected useful life. To find out, you can check IRS Publication 946, Appendix B, which lists estimates for the useful life, listed by industry and application. Or, you can go by the manufacturer’s specifications.
For items you have experience with, you can take a historical viewpoint. In other words, you expect similar items to last the same amount of time. Also consider how much it will be used and under what conditions.
Next, you need several bits of information about the depreciation, including:
- The method of depreciation you are using.
- How much you can deduct in depreciation for the current year.
- The cumulative amount you will depreciate over its useful life.
- The net value of the item.
It’s usually best to use software or an accountant to figure your depreciation for your small business tax return. It’s a complicated calculation that has many intricate rules and requirements. However, the more you know during the year, the better you can make informed business decisions. So, it will help you to create a working depreciation schedule.
Figuring depreciation for your assets can be a difficult chore. Yet, it benefits your business by lowering your tax burden. It helps you make the right decisions in buying, maintaining, and selling your assets. Furthermore, learning the formulas you should use makes the process easier and more sure. Also, for small businesses that rely on accounting software, the knowledge helps you know if you have a mistake in your books. It also helps demystify the process.
To learn more about calculating business taxes, you can read a complete guide on tax credits and deductions. Or, you can read articles on taxes for home businesses. Either way, understanding how to calculate small business interest decreases your frustration as well. Then, after you learn and implement these processes into your business accounting, you can reap the rewards year after year.
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