Depreciation: the act of driving your new car off the lot and significantly reducing its value before you’ve even reached your first stoplight. Okay, that view’s a bit cynical. If your mind jumped to the same thing, then this quick and dirty guide is going to introduce you to your new best friend. Well, maybe not your best friend, but for sure among your top 5. As a small business owner, depreciation isn’t your enemy—it’s your ally.
How Does Depreciation Work?
When you buy an item, it loses value over time. It suffers wear and tear and becomes outdated while its usefulness diminishes with each passing year. It depreciates. But without accounting for depreciation in your expenses, you’d be forced to deduct the cost of every asset you bought the year you purchased it—even if you plan on using that asset for the next 15 years.
Depreciation spreads the expense of your business assets over their useful life. And this spreading of your depreciation expense comes with some fantastic fiscal benefits.
Benefits of Depreciation
1. Strategize Your Tax Savings
Depending on which depreciation method you use (more on that later), you get to decide your asset’s depreciation schedule. This schedule dictates when you report depreciation expenses, and this timing determines how much you can claim for tax deductions. So, for once, you’re in a bit more control over your tax obligations.
2. Recover Your Costs
By depreciating your assets over a predetermined period, you’ll know how much you should be saving to replace the asset once its useful life expires. So, for example, if your delivery van straight-line depreciates $2,000 a year, then you know you need to be saving at least $2,000 a year to replace it.
3. Provide Accurate Financials
If you only recorded and reported the purchase value of your assets, then you’d be misleading yourself and potential investors and lenders. Depreciating assets lets you know your actual up-to-date potential liquidated cash. And it lets you know when you’re likely going to need to replace certain equipment and machinery—without the need for visual cues like smoke and sparks.
What Assets Depreciate?
According to the IRS’s Publication 946, vehicles, machinery, heavy equipment, computers and office equipment, and real estate (excluding land) are all depreciable assets. In addition, assets must meet the following requirements:
- You must own the asset.
- You must use the asset for business- or income-producing activities.
- Your asset must have a determinable useful life.
- Your asset must be expected to last at least 1 year.
In certain scenarios, even intangible assets like patents, copyrights, and software can be listed as depreciable.
4 Common Methods of Depreciation
There isn’t one right way to depreciate your assets. 4 conventional methods prevail, and each is appropriate depending on the asset and your business operations. You (or your accountant) will need to crunch the numbers to see the financial impact each depreciation method will make before choosing.
The straight-line depreciation method is by far the most common. You essentially depreciate the same amount each year for the useful life of your asset. This depreciation method is great for its simplicity and tax deductions.
Units of Production Method
Rather than depreciating based on time, the units of production method depreciates depending on how many goods or services the asset produces. It’s more concerned with the output potential instead of how long you’ve owned the asset.
Double-Declining Balance Method
Double-declining balance depreciation is an accelerated method that reports higher costs early on but then expenses less and less over the life of the asset. This method is great for vehicles and electronics that tend to lose value at a faster rate (like the car you drove off the lot or last year’s iPhone).
Sum-of-the-Years-Digits Depreciation Method
Sum-of-the-years-digits depreciation is another accelerated method—not quite as fast as double-declining but still faster than straight-line. This method more accurately depreciates an asset’s usefulness—the asset being the most valuable early on and decreasingly so as it nears the end of its life.
Section 179 and Bonus Depreciation
Thanks to Section 179 and bonus depreciation, you can deduct the entire cost of your property the first year it is put to work. Section 179 allows you to fully depreciate new and used assets while bonus depreciation only allows new assets. By depreciating the full cost of the asset immediately, you’ll be able to use the tax savings to offset the initial expense of the investment.
Depreciation—The More You Know
While you don’t need to become a depreciation wizard, understanding the basics will empower you to maximize your depreciation potential. Now at least your eyes won’t glaze over when your accountant says the “D” word, and you’ll be prepared to make the best decisions for your business.