If you’ve already read A Beginner’s Guide to Depreciation of Assets and you’re ready to start calculating, then you’re in the right place. Keep reading to learn about the methods for calculating depreciation for managerial and tax purposes, bonus depreciation, and amortization.
Depreciation for accounting purposes
In accounting, depreciation is the cost of a tangible asset over the span of its useful life. When determining a company’s net income, these non-cash expenses are subtracted from the company’s revenue.
There are several ways to calculate depreciation. We’ll cover two standard methods: straight-line and accelerated.
This is the most common and simple way to calculate how much a specific asset loses in value over time. Because the straight-line method uses a constant rate of depreciation, the expense is distributed equally over all periods of the asset’s usable life.
Straight-line formula: (Asset cost – salvage value) / useful life
For example, Penny’s Printing Company purchases a printer for $20,000. It’s determined that the printer has a useful life of 10 years and a salvage value of $1,500. Therefore:
(20,000 – 1,500) / 10 = $1,850 annual depreciation amount
Using an accelerated depreciation method allows you to deduct more expenses earlier in the asset’s useful life. Double declining balance depreciation is a common accelerated method—most useful for assets with a higher productivity earlier in its useful life, like a vehicle. This method is more complicated than straight-line, but also more accurate.
Double declining balance method formula: (100% / life of asset = depreciation rate) x 2
Let’s say Penny also purchased a $30,000 delivery van for her printing company. For bookkeeping purposes, she would calculate depreciation by first determining that the useful life is 10 years and the salvage value is $3,000.
Using the formula above, the depreciation amount will be $6,000 in the first year, $4,800 in the second year, $3,840 in the third year, and so on until hitting the salvage value.
These depreciation methods help measure the company’s net income in each accounting period.
Depreciation for tax purposes
Before jumping into calculations, it’s important to have the appropriate resources for tax depreciation. You’ll become familiar with the IRS website and information on how to depreciate property, including details on completing form 4562.
As we discussed in the previous article, depreciation can result in valuable income tax deductions for small business owners. And income tax deductions can mean—cha ching!—a savings of thousands of dollars each year. But understanding exactly how to calculate and claim the deduction can be confusing.
In the tax world, the method for depreciating property is called the Modified Accelerated Cost Recovery System (MACRS).
MACRS can be used on property such as vehicles, furniture, office equipment, machines, buildings, and other tangible items that deteriorate in value over time. While the IRS allows for depreciation of intangible items such as copyright, recordings, computer software, etc., that process is actually called amortization. Read on for details.
Before beginning to calculate MACRS, you will need to first identify the following items: cost basis, property class, placed-in-service date, and appropriate convention.
- Cost basis: This is the total cost of acquiring an asset and making it usable. In addition to the purchase price, cost basis also factors in sales tax, shipping/delivery fees, installation fees, and maintenance/improvement costs. The last item is especially relevant for rental real estate (find more info in IRS Publication 527).
- Property class: Under MACRS, each asset is assigned to a class and a coordinating designated depreciation period.
Check out the chart below for some common examples:
|3-year property||Tractors, horses, qualified rent-to-own property|
|5-year property||Vehicles, office machinery, computer equipment, cattle|
|7-year property||Office furniture|
|10-year property||Water transportation system, some agricultural equipment|
|15-year property||Some land and tenant improvements|
|20-year property||Municipal sewers, farm buildings|
|27.5-year property||Residential rental properties|
|31.5-year property||Non-residential property|
These categories are also important because they indicate which declining balance method should be used. For property with a usable life of 3, 5, 7, and 10 years, the 200% declining balance method is used. In this case, you will take 200% of the amount that would be depreciated using the straight-line method. Similarly, 15-year property uses the 150% declining balance method—here you will claim 150% of the amount that would be depreciated using the straight-line method.
- Placed-in-service date: An asset is “in service” when it’s set up and ready for use. This date can differ from the purchase date. If Penny purchased her printer in October but it’s not delivered and installed until December, she starts deducting MACRS depreciation in December.
- Convention: There are three different conventions that can be used to determine depreciation in the first year of an asset’s life:
- Mid-month convention – This convention assumes the asset was purchased in the middle of the month, most often used on buildings. So, if Penny purchased the building for her printing company on October 29, the mid-month convention method states that she bought it on October 15.
- Mid-quarter convention – Fixed assets purchased during a report quarter should depreciate as though they were acquired in the middle of the quarter. An asset purchased in July, for example, is purchased in the third quarter. The middle of the third quarter (July-September) is August.
- Half-year convention – This convention applies to any property that doesn’t require one of the previous two conventions. The half-year convention assumes an asset has been in service for one-half of its first year despite when it was actually acquired. For an asset purchased in February, you can claim a half year depreciation.
Now that you have the info you need to start calculating, you’ll begin with the first year:
First year depreciation = basis x (1 / useful life) x depreciation method x convention
In the subsequent years, you would use the following formula:
Subsequent years depreciation = (basis – depreciation in previous years) x (1 / useful life) x depreciation method
Let’s say Penny also purchases a copier machine with a cost basis of $10,000 and the half-year convention applies. Office equipment is a five-year property so she would use the 200% declining balance method.
The first year’s depreciation for Penny’s copier would be:
10,000 x (1 / 5) x 200% x .5 = $2,000
For the second year, depreciation would be calculated as:
(10,000 – 2,000) x (1 / 5) x 200% = $3,200
When do you stop depreciating an asset? There are a number of actions that can change the status of property–but only one is needed. Depreciation stops when a property is:
- Sold or exchanged
- Converted to personal use
- Transferred to a supplies or scrap account
Bonus depreciation is a method of accelerated depreciation the IRS designed to stimulate investment in business property (not buildings or land) and is referred to as “special depreciation allowance.”
Bonus depreciation allows your business to take an immediate first-year deduction on the purchase of eligible business property, in addition to other depreciation. Qualified property has a useful life under 20 years and has to be new or new to you, and is claimed in the taxable year that the asset is “placed in service.”
This calculation is determined by using the bonus rate, which is prevailing in the market. The calculation involves multiplying the rate with the cost of the asset. The tax on the property is then deducted from the cost of the asset. With a tax rate of 20%, Penny’s copier machine would have a $2,000 deductible rate, which should be used in the first year the copier is in service.
What about intangible assets?
Your intangible assets—like copyrights, software, videos, etc.—are allowed depreciation as well. This can be written off as an expense over a period of years through a process called amortization. This process differs from depreciation in the sense that it doesn’t take into account salvage value on an asset. While the IRS says that most intangible items are required to be amortized over a 15-year period, some exclusions apply.
Amortization is most commonly calculated using the straight-line method. For example, if your asset value is $60,000, divide that by 15 to get your yearly $4,000 amortization deduction.
A final word on depreciation
It may seem like a lot of charting, computing and calculating, but taking the time to determine depreciation (or amortization) of assets can have a big impact on your small business. If you’re running a small business, you’re most likely not an accountant. There are many online resources available to help you navigate these tricky calculations—including MACRS calculators. Or, save it for the pros!