Depreciation is a tax-deductible expense for businesses. It is an accounting method of spreading the cost of assets over several years.
Businesses can deduct the depreciation expense for qualified assets and use the allowed methods.
Let us discuss what is the depreciation expense and is it tax-deductible.
What is Depreciation?
Depreciation is the method of cost allocation of fixed or non-current assets over the years.
Depreciation is an accounting process that spreads the total cost of acquiring tangible and physical assets over several accounting periods.
Tax depreciation is a similar process but with a different approach. It is the process of calculating the depreciation charge (or simply expense) that can be allocated in the accounting period.
Tax depreciation charge is a tax-deductible expense. Although it is a non-cash entry that does not involve actual cash outflow, it is a deductible expense.
A business can deduct the cost of purchasing fixed assets up to certain limits for tax purposes. Tax regulators like the IRS guide the cost allocation process. Therefore, calculating the tax depreciation charge is an important obligation for a business for tax compliance purposes.
Depreciation Expense Vs Accumulated Depreciation
Accumulated depreciation is a balance sheet item whereas depreciation is an income statement item.
When a business calculates depreciation charges, it records a journal entry in its account books first. This represents an annual depreciation expense that can be charged against a tangible asset.
Likewise, the business will calculate the depreciation charge for all qualified tangible assets. Tax depreciation expense can be calculated by using approved methods only.
The tax depreciation expense is then listed on the income statement of the company. It is listed after deducting admin and operating expenses and before writing the EBIT line.
The collective amount for every accounting period (a year) is then recorded on the balance sheet of the company. This line item will increase (or decrease) every year as the business will charge the depreciation expense.
The accumulated depreciation is then deducted from the total book value of these assets. Once a tangible asset has been fully depreciated, its accumulated depreciation is removed from the balance sheet.
A business can follow the same process for the amortization and depletion expenses for intangible assets and natural resources respectively.
Is Depreciation Tax Deductible?
Depreciation is an allowed and deductible expense for tax purposes.
For instance, the IRS allows depreciation as a tax-deductible expense for qualified assets and businesses can use it for reducing their tax liabilities.
Tangible assets such as property, machinery, and equipment can be depreciated using specific useful life limits as issued by tax regulators.
For instance, the IRS allows the useful life of an asset in different categories as discussed below.
- Manufacturing tools have a useful life of three years
- Office equipment, computers and laptops, and construction equipment can be depreciated up to seven years
- Commercial property can be depreciated up to thirty-nine years
Similarly, the IRS provides useful life limits for different asset classes.
Businesses can also recover the full cost of purchasing an asset in one year. However, the IRS puts an upper limit for the full depreciation expense in one year.
Currently, the IRS allows up to $ 1,080,000 of depreciation expense in one year for an asset and up to $ 2,700,000 for the cumulative depreciation expense for all tangible assets.
Depreciable and Non-depreciable Assets
Depreciation is an allowed and deductible expense by the IRS for tax purposes. However, a business must evaluate the qualification of assets that can be depreciable or non-depreciable.
The IRS provides guidelines on deciding whether your property including other physical assets such as office equipment, machinery, computers, etc. are depreciable or non-depreciable.
The land is a non-depreciable asset; however, land improvements can meet the qualification criteria to be depreciable expenses.
Generally, an asset is depreciable if:
- You own the asset.
- The asset must be used for business purposes or other investment activities.
- The property has a determinable and useful life that must be more than one year.
- The property must not be an exceptional property as guided by other IRS regulations.
If you use an asset for both business and personal uses, you can only deduct the business usage for tax deductions.
How to Calculate the Depreciation Expense?
First of all, a business would need to determine whether an asset is depreciable as discussed above.
Then, the business will evaluate the cost basis of an asset. It means it will calculate the total cost of purchasing the asset including the purchase price, sales tax, freight, and other direct expenses.
A business can choose different methods to depreciate tangible and intangible assets.
Straight-Line Depreciation Method
In this method, a business will divide the total cost of an asset into equal parts for the useful life years. For instance, if the useful life of a computer is five years and it costs $2,000, the business will deduct a $4oo yearly depreciation expense.
A declining or double-declining depreciation method is used to accelerate the depreciation expense for tax savings.
A business will deduct depreciation expense from the total value of the asset up to the allowed limit in the first year. Then, it will gradually deduct the remaining balance in the following years until it reaches salvage value.
Section 179 Deduction
The IRS allows businesses to deduct depreciation expenses in one year as well. However, as mentioned above, section 179 restricts the depreciation deduction for one asset up to $ 1,080,000 and $ 2.7 million for all assets in one year.
Income Forecast Method
This method is used to calculate the depreciation charge for certain intangible assets such as patents, copyrights, videos, and sounds.
The Modified Accelerated Cost Recovery System (MACRS)
The modified accelerated cost recovery system (MACRS) is the process of deducting depreciation expense for taxpayers in the US.
The MACRS is not recognized by the US GAAP rules yet. Therefore, it can only be used for tax depreciation purposes and not for financial statements.
The MACRS classifies assets into different classes. As mentioned above, the IRS allows different periods for charging the depreciation expense for different types of assets.
Therefore, it is important for a business to classify each asset into the right category and record the correct useful life for tax purposes.
The MACRS further uses two types of depreciation calculation systems.
The first one is the General Depreciation System (GDS) which uses the declining depreciation method to calculate the depreciation expense.
This method allows businesses to charge higher depreciation in the early years to take early tax savings.
The second method is the Alternative Depreciation Method (ADS) which uses the simple straight-line calculation method. The ADS allows businesses to evenly spread the cost of the asset over several years.
The IRS allows using both of these methods for tax depreciation purposes.
Impact of Depreciation on Taxable Income
Depreciation is an income statement item as well as the balance sheet item. It means it will affect a business in at least two ways.
As depreciation is tax-deductible, it reduces the tax liability of a business. It is listed above the EBIT and after deducting the direct COGS and other important expenses.
Therefore, the tax impact of depreciation is direct and significant. Further, a business can choose to deduct accelerated or decelerated depreciation expense as needed.
If a business performs well and generates higher profits, it can use accelerated methods such as the double-declining method to charge higher depreciation and lower the taxable income.
Secondly, depreciation affects the cash flow of a business. Although it is a non-cash item and the business does not incur an actual cash outflow.
A business must add back the depreciation charge to accurately calculate its cash flow in the cash flow statement. However, as the business saves on taxes and improves its balance sheet, the depreciation charge positively impacts a business.
In the long run, the depreciation charge does not impact the operating cash flow of a business as it does not have actual cash flow.
Indirectly, a business would improve profits by reducing tax liabilities. Therefore, its financial performance metrics will improve considerably.
Accounting Depreciation Vs Tax Depreciation
It is not uncommon for businesses to keep two types of records for depreciation calculations.
The accounting depreciation follows the Generally Accepted Accounting Rules (GAAP) or the IFRS rules as decided by the business. It is used as an accounting practice to depict the accurate book values of non-current assets.
Different stakeholders such as managers, shareholders, and regulators see accounting depreciation in different ways. Most commonly, it serves the accounting purposes of cost allocations, book value calculations, and estimating the useful life of assets.
Contrarily, tax depreciation follows the regulatory requirements. It also serves tax compliance purposes.
Tax depreciation is used to calculate the tax-deductible expense for a business as well as to comply with the rules.
In short, although both types can use the same method to calculate the depreciation expense, they serve different purposes for a business.