Depreciation… one word that can make a business owner (and even many accountants) cringe.
However, understanding it and how to implement it correctly in your business can make a big impact. That is exactly what I will be talking about here.
What Is Depreciation?
At a very basic level, depreciation is simply the process of spreading out the expense for an asset purchase over time. When you buy personal property (such as a car, computer, or other equipment) or real property (such as a building) you have a few possible options for deducting that cost.
The kinds of property that you can depreciate include machinery, equipment, buildings, vehicles, furniture, etc.
You can’t claim depreciation on property held for personal purposes. If you use property, such as a car, for both business or investment and personal purposes, you can depreciate only the business or investment use portion.
Land is never depreciable, although buildings and certain land improvements may be.
Purchases not expected to last more than one year you would simply expense immediately.
What Options Do You Have for Deducting Asset Purchases?
- Regular Depreciation: Can take anywhere from 3 to 39 years, depending on the type of asset purchased.
- Bonus Depreciation: Allows you to deduct a percentage of the cost of personal property upfront.
- 2022: 100%
- 2023: 80%
- 2024: 60%
- 2025: 40%
- 2026: 20%
- 2027: 0%
- Section 179 Expensing: Allows you to deduct up to $1,160,000 (2023) of the cost of personal property in one year.
What Is a Basic Example of Depreciation?
Lets imagine you purchased a brand new computer for $4,500 on January 12, here is how it would work.
With Regular Depreciation, a computer is considered a 5 year asset so your $4,500 purchase would be spread out across 5 years.
With Bonus Depreciation or Section 179 you would potentially be able to deduct the full $4,500 in year 1.
What are the Rules Around Depreciation?
Rule #1: You Must Be In Business
- If you just have property that is simply for personal use, it is not deductible.
- If you purchase an asset with the intent of opening a new business, no depreciation would be allowed until your business actually begins. This doesn’t necessarily mean you need to have revenue coming in or be profitable but you need to be operating as a “going concern”.
Rule #2: Depreciation Begins When You Place Property In Service
- You don’t have to use the property to place it in service, but the property must be available for use in your active business.
- Example 1: You purchase a computer for your business on December 15th but then send it back in to get software and everything else loaded onto it so you can actually use it and you get it back ready to use on January 10th.
- This would be considered placed in service on January 10th, not December 15th.
- If the computer came ready to use right away then December 15th would be the date in service.
- Example 2: Rental property would be considered placed in service the day it is ready for occupancy and listed for rent but would not have to be physically rent to be considered in service.
When Does Depreciation Begin?
- Bonus Depreciation or Section 179: You get a full deduction for the year you place the property in service, regardless of the month it was placed in service.
- Regular Depreciation: You must apply rules called conventions to determine the month in which your depreciation deduction begins. The earlier in the year, the larger your deduction for the first year.
What Happens If I Sell a Depreciated Asset?
If you sell a depreciated asset you may have a gain or loss on the sale. First you need to find out your basis which in simple terms would be your purchase price less any depreciation. Then your gain or loss would be your sale price minus your basis. Here’s a quick example:
- Purchased Computer for $4,500
- Took Full $4,500 Bonus Depreciation in Year 1
- Sell for $2,000 in Year 3
Your basis would be $0 ($4,500 Purchase Price – $4,500 Depreciation) so your gain would be $2,000 ($2,000 Sales Price – $0 Basis), which would be taxable. This is often times referred to depreciation recapture.
In that same example if you only had depreciated $1,500 instead, then your basis would be $3,000 and you would actually have a $1,000 loss ($3,000 Basis – $2,000 Sale Price).
What Is a Capitalization Policy and Should I Implement One?
Setting up a capitalization policy allows you to immediately expense items under $2,500 without having to even worry about depreciation. The IRS refers to this as a “safe harbor” which basically means they will accept your expensing of a qualified asset if you property abide by the rules of the safe harbor.
This is something that ever business should take advantage of.
- It is superior to Section 179 expensing because you don’t have the recapture period that can complicate your taxes.
- It takes depreciation out of the equation, instead you get a full expense in year 1 just like as if you purchased pens and paper.
- It simplifies your tax and business records because you don’t have the assets cluttering your books.
Lets go through an example. Lets imagine you bought two new desks for $4,400 ($2,200 each). If you did not use the safe harbor you would need to capitalize and depreciate each desk and keep them on your books as an asset. With a safe harbor you would simply expense them immediately as “office expenses” which makes your life much easier.
To take advantage of this safe harbor you need to:
- Have a Capitalization Policy in Place
- This needs to be done at the beginning of the year.
- Must indicate expensing allowed up to the $2,500 IRS safe harbor limit. Note: You can choose a lower number should you wish but $2,500 is the max.
- You must follow your policy for all asset purchases that meet the thresholds, you cannot pick and choose some to depreciate.
- Be sure to keep invoices on file. This is especially important if you have multiple asset purchases on one payment. In the example above you’ll want the invoice to prove it was two purchases at $2,200 and not one at $4,400.
- Make an Election on Your Tax Return
- When you file your tax return you will want to make an election for you to use the safe harbor expensing which is simply a statement you will want to include with the filing.
As part of our Tax Minimization Program we have a sample capitalization policy document you can use to put in your internal records.
- Depreciation cannot begin until you have an active business.
- Depreciation for business property in an active business can only begin once the property is placed in service (available for use in the business).
- If you use property for both business and personal purposes, you can depreciate only the business use portion.
- Implement a capitalization policy in your business to take advantage of the IRS safe harbor so you can immediately expense asset purchases under $2,500 without having to worry about depreciation.
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