How to Calculate Depreciation Expense for Your Business
The IRS provides various methods to calculate depreciation expenses on assets owned and used by your business. Depreciation is an income tax deduction that businesses can claim to recover the cost basis of most tangible—and some intangible—pieces of business-related property.
Effectively, depreciation covers the wear and tear, deterioration, or obsoleteness of assets like vehicles and equipment that are used to earn income and helps you budget for upgrades and replacements.
IRS-Approved Methods for Calculating Depreciation
There are two IRS-approved methods under the MACRS system for calculating the depreciation of your assets for tax purposes. Choosing the right method can be complicated for business owners. That's why getting help from a business accounting professional is essential.
The MACRS System
The Modified Accelerated Cost Recovery System (MACRS) is the appropriate depreciation method for most assets. This system allows for a bigger tax deduction in the early years of an item's useful life and gradually reduces the amount as time goes by.
MACRS can only be used for business assets purchased after 1986; assets bought before 1987 are subject to the Accelerated Cost Recovery System (ACRS). The two systems that are allowed under the banner of MACRS are the General Depreciation System and the Alternative Depreciation System.
General Depreciation System (GDS)
The General Depreciation System is the most popular system for calculating depreciation. The GDS recovery period is shorter than the ADS recovery period. Within the GDS, there are two popular options: the Straight-Line Method and the Declining Balance Method.
Timelines
To see the recovery periods for property your business owns, refer to the IRS's table in Publication 946, Appendix B, page 97.
Straight-Line Method
The Straight-Line Depreciation method is a simple method to calculate depreciation and amortization. It is calculated by dividing the difference between the asset’s cost and its salvage value—the estimated sell-on value the business expects to receive when the asset is no longer needed—by the number of years a business expects to use the asset to generate income.
In simple terms:
(Asset Cost – Estimated Salvage Value) / Useful Life = Yearly Depreciation Deduction
Declining Balance Methods
The depreciation rate using the Declining Balance Method and Double Declining Balance Method are typically 150% or 200% respectively of the straight-line depreciation rate.
The Declining Balance Depreciation formula is:
Declining Balance Depreciation = CBV × DR
where: CBV = current book value and DR = depreciation rate (%)
Current book value is calculated by deducting accumulated depreciation from the initial cost of the fixed asset. The depreciation rate is the straight-line depreciation rate multiplied by 1.5 for 150% depreciation and by 2 for 200% depreciation (double depreciation).
Alternative Depreciation System (ADS)
Knowing when to use the Alternative Depreciation System (ADS) is important because being able to accurately calculate depreciation expenses can lower your business's taxes. The rules regarding ADS are complex, which is why many businesses in Jacksonville, Florida, as well as the other states we serve, ask our tax professionals to do the calculations for them.
Using the ADS increases the number of years over which you can depreciate an asset. This can be appealing as it means you can reduce your taxable income over a longer period.
To calculate the annual depreciation expense, use the following formula:
(Cost of Asset - Salvage Value) / Useful Life
In this formula, the useful life of the asset is based on the IRS’s 2022-23 recovery periods under the Alternative Depreciation System (pages 31-32).
Determine the Convention
Conventions establish when recovery periods begin and end. This affects the number of months you can claim depreciation in the year you dispose of the property and in the year you bought it. The possible conventions are mid-month, mid-quarter, and half-year.
You must specify which convention you choose in Form 4562.
Special Cases
Because exceptional cases sometimes exist, it's best to talk to an accountant to find out if you qualify for any extra tax benefits. The following are two of the most frequently claimed benefits.
Section 179 Deduction
This deduction allows you to claim all or some of the cost of qualifying property in one go. To do this, you must deduct the qualified amount in the year the property is placed in service. You can choose the Section 179 deduction instead of recovering costs through depreciation deductions.
There are new regulations for tax years starting in 2023 that businesses should be aware of:
For the 2023 tax year, the maximum Section 179 deduction expense is $1,160,000 with a phase-out threshold of $2,890,000.
If your business spends $4.050 million or more on equipment during the 2023 tax year, Section 179 does not apply.
Bonus Depreciation
Bonus Depreciation can be used to cover the portion of equipment purchases that exceed the Section 179 limit. For qualifying assets purchased between 27 September 2017 and 1 January 2023, Bonus Depreciation covers 100% of the overflow. For 2023, it covers 80%. The percentage will then decrease by 20% each year until it reaches 0% in 2027.
Generally Accepted Accounting Principles (GAAP) Methods for Calculating Depreciation
Calculating depreciation for tax purposes and accounting work on slightly different principles, but both use similar methods to calculate the amount of annual depreciation.
Straight-Line Method
You can deduct the same amount each year over the item’s useful life using this method.
The yearly depreciation deduction will stay the same throughout the item's lifetime unless there's a significant change in the adjusted basis or useful life.
Declining Balance
With this accelerated depreciation method, the annual depreciation of an asset is greatest in the year of the purchase and smaller each subsequent year. The Declining Balance Method and the Double Declining Balance Method are most appropriate for assets that lose most of their value early on.
Sum of the Years’ Digits
The SYD method accelerates depreciation more than the Straight-Line Depreciation method but not as quickly as the Declining Balance Method. This method uses the total number of years of an asset's useful life. This is another option for assets that lose value quickly or have a greater production capacity early on.
Units of Production
This awards an equal expense rate to every unit produced by the piece of equipment. This can be the best option when an asset's value depends on how many units it produces or how much it's used.
Consult a Tax Professional
Knowing the basics of depreciation and how it can work for your business is a huge plus. However, consulting a tax professional is crucial because determining details like the basis, start and end date, and the rate of depreciation can be very nuanced.
As depreciation is often calculated differently for tax vs. accounting purposes, consulting an expert will help you ensure that you get the best possible tax return. A professional can also help you make strategic asset purchase and sale decisions to improve your bottom line.
