With 2022 in full swing, it’s time to officially wrap up 2021—meaning it’s time to tackle your taxes. As a small business owner, it’s important to understand which tax deductions your business is eligible to take before you file. One deduction that is commonly misunderstood, and sometimes even overlooked, is depreciation. If you’re a small business owner, you’ll learn to appreciate depreciation.
In simple terms, depreciation is the process of deducting the total cost of a higher-priced item you bought for your business by writing off parts of it over its useful life—not all in one tax year. Keep reading to learn more about what depreciation is and what can and cannot be depreciated.
In financial terms, we tend to hear a lot about appreciation, so let’s start there. Appreciation is an increase in value of an asset over time. Think stocks and bonds, gold and silver, land and real estate. Most people are also familiar with why appreciation occurs—increased demand, weakening supply, or changes in inflation or interest rate.
On the other hand, depreciation is a decrease in the value of an asset over time. The common reasons behind depreciation are age, wear and tear, decay, or obsolescence (when the item is outdated or no longer used).
The example most people think about here is buying a new car—it starts depreciating as soon as you drive it off the lot. It sounds like a total bummer, but there is a silver lining to depreciation: it can mean a deduction on your taxes and a savings of thousands of dollars each year for your business (more on that later).
Another related term is assets, which are basically items with a high dollar value. In IRS terms, however, assets are referred to as “property” and include items that can generate revenue or be converted to cash. Automobiles, machinery, real estate, investments and patents are just a few examples of business assets. They add value to your company because they are used to produce goods and provide services. Business assets keep your doors open and your company growing—pretty important, right?
Last (but certainly not least), a deduction is an item or expense you can subtract from your taxable income to lower the amount of taxes you owe to Uncle Sam (and increase the amount of money in your bank account).
So, to put it all together… come tax season, you might be able to take deductions based on the depreciation of your business assets. We’ll save the “how” for a separate post; for now let’s keep learning more about depreciation and what it means for you as a small business owner.
What can be depreciated?
The IRS says you can depreciate most types of tangible property—tangible meaning things you can actually touch. Examples include machinery, vehicles, furniture, buildings, computers, printers and other equipment. As mentioned above, land doesn’t wear out—it actually appreciates. But what can be depreciated are improvements you’ve made to the land, such as fencing, parking lots, side walks, roads and landscaping.
An item that is depreciable must be something that you actually own. The IRS still counts an item as being owned by you even if you are in debt on the item. So that car you drove off the lot? If it’s for business purposes—maybe you make product deliveries with it or you use it to provide a courier or chauffeur service—it can be depreciated. Even if you are continuing to make payments on the car, the government still considers that to be property you own (and therefore depreciable).
Besides the requirement that it must be property you own, there are other specific qualifications the government says an asset must meet in order for it to be depreciable. You must use this item in your business or in an income-producing activity. Also, the item must have an expected useful life, and that useful life must be determined to be longer than one year. Example: If you buy a commercial carpet cleaner machine for your building but then stop using it within the year, it’s not a depreciable item.
There are also intangible items—things you can’t touch—that can be depreciated, such as patents, copyrights, computer software and intellectual property. If they meet the criteria, they can be written off as an expense over a certain period of time. This process is called amortization, which is something we’ll cover in our “how to” post.
What cannot be depreciated?
Not all items are depreciable just because they are something that you own and can touch. You may know how much you spent on paper, staples or pens, but—unlike copiers or printers—low-cost items like office supplies are not depreciable.
Inventory is also not depreciable because it is held for sale to your customers and not for use in your business. This can be a tricky area to navigate, so the IRS goes into greater detail and provides examples to help you better understand how inventory is handled.
As previously mentioned, you can’t depreciate items that aren’t expected to have a useful life longer than one year. You also can’t deduct property that you lease or rent (though, again, the improvements you make to the property can be depreciable).
Personal vs. professional assets
Now, let’s discuss items that you use in your personal life. Anything that you use personally—cars, housing, home computer, printer, etc.—cannot be depreciated. There is a common exception, however, and that involves items that are used both personally and professionally. If you have an item that fits this case—like a laptop, camera or automobile—you can depreciate a portion of it based on the amount of time it’s used for business purposes.
Back to that car… let’s say you put 10,000 miles on it last year. You racked up an easy 6,000 miles running family errands, driving kids to activities, and a couple of road trips. Those are all considered personal use. But, if you can document that the remaining 4,000 miles were for business purposes, you can depreciate 40% of the cost of the car. A note of caution—you cannot claim depreciation on a car if you also claim mileage deductions.
If you work out of your home, the entire house isn’t depreciable—but a percentage of it could be depreciated. Same with your laptop and other machines or equipment that split time between your personal and professional life.
NOTE: Adequate record keeping is key to the depreciation process for multi-use property. Documentation of personal and professional use will be required–find out more about what records must be kept.
Why is depreciation good for business?
And now for the silver lining to the concept of depreciation—how it can benefit your business. The most obvious reason is because it saves you money. Yes, depreciation of assets can reduce the amount of money you owe in taxes. But in addition to decreasing your tax burden, there are several other reasons for small business owners to discover an appreciation for depreciation.
A major advantage to depreciation is that it allows businesses to properly match an expense incurred from a particular asset with the amount of revenue that asset is intended to generate in a given period of time. This helps businesses to more clearly determine the value of an asset—and report financial information with better accuracy.
Additionally, machines, technology, automobiles and other assets that drop in value over time will eventually need to be replaced. The process of depreciation can be useful to businesses in determining how long assets will hold their value and when new assets will need to be purchased. In turn, this enables businesses to more closely plan and manage cash requirements—which is especially helpful for small business owners hoping to make large purchases in the future with cash instead of loans.
Coming up next
As a business owner, you will record the full cost of an item for bookkeeping purposes—but you can’t write it all off in one tax year. Just like the IRS has rules on what can be depreciated, there are also rules on how items can be depreciated.
In our next post on this topic, we’ll go into detail about the methods used to depreciate business assets for managerial purposes, how to calculate and keep track of depreciation for tax deduction purposes, as well as some bonus information on depreciation.