Depreciable Assets Overview
Depreciable assets help businesses recover costs over time, reducing taxable income and improving cash flow. Understanding how to correctly depreciate property ensures you maximize tax benefits while staying IRS-compliant.
What Are Depreciable Assets?
Depreciable assets are business resources that provide value over time and help generate income. These assets gradually lose market value due to wear and tear, obsolescence, or usage. Businesses can recover the original cost of these assets through depreciation, reducing their taxable income each year.
To qualify as depreciable property, an asset must meet specific IRS criteria:
Be owned by the business (i.e., not leased)
Be used in a business or income-producing activity
Have a determinable useful life of more than a year
Lose value over time, rather than maintaining or appreciating in market value
Depreciable vs Non-Depreciable Assets
Businesses must correctly classify assets to ensure they take the right deductions and follow IRS regulations.
Depreciable Assets
These business assets lose value over time:
Tangible Assets:
Machinery and equipment used in income-producing activities
Vehicles for business operations
Buildings and real estate
Furniture
Computers and technology
Fixtures and fittings
Capital improvements (building renovation, new HVAC system, new roof, land improvements like parking lots and outdoor lighting)
Intangible Property:
Patents
Copyrights
Trademarks
Computer software
Note: Some intangibles follow IRS Section 197 amortization rules.
Non-Depreciable Assets
These assets do not lose value over time or they have an indefinite lifespan:
Land
Investments (stocks, bonds)
Collectibles (art, coins)
Grazing permits and water rights
Supplies
Cash
Proper classification affects how your business reports expenses, calculates net income, and claims tax deductions. A small business accounting professional can ensure your business's assets are categorized correctly to avoid tax issues and maximize deductions.
How Depreciation Works in Business Accounting (Step-by-Step)
Here’s how the depreciation process works:
Determine the Asset’s Entire Cost: Includes the purchase price, taxes, shipping, and any costs to prepare the asset for use.
Estimate its Useful Life: Based on IRS depreciation schedules and the asset’s expected lifespan in business operations. Some assets, like vehicles, depreciate quickly, while others, like buildings, decline more slowly.
Determine the Salvage Value: Also called residual value, this is the estimated market value of the asset at the end of its useful life.
Choose a Depreciation Method: Businesses select from IRS-approved depreciation methods, depending on their tax strategy and financial goals.
Calculate Depreciation Expense Each Year: The depreciation expense is recorded annually to reduce taxable income and adjust the asset’s book value.
Common Depreciation Methods & Examples
The IRS tax code allows various depreciation methods to allocate an asset’s cost over time.
Example Asset: A restaurant in Jacksonville, Florida, buys a commercial bread oven for a total cost of $24,000. It has an expected useful life of 8 years and an estimated salvage value of $2,000.
Here is how five depreciation methods apply to this kitchen equipment depreciation example:
Straight-Line Depreciation: Spreads the depreciation expense evenly each year.
Formula: (Cost - Salvage Value) ÷ Useful Life
Calculation: ($24,000 - $2,000) ÷ 8 = $2,750 per year for 8 years
Depreciation rate: (1 ÷ 8 years) = 12.5% per year
Declining Balance Method: Accelerates depreciation in early years by applying the straight-line percentage (12.5% in this example) to the remaining book value.
Formula: (Remaining Book Value × Depreciation Rate)
Calculation:
Year 1: $24,000 ×12.5% = $3,000
Year 2: $21,000 ×12.5% = $2,625
Year 3: $18,375 ×12.5% = $2,297 and so on
Double-Declining Balance Method: Uses double the straight-line rate to front-load depreciation.
Formula: (2 × Straight-Line Rate) × Remaining Book Value
Calculation: Straight-line rate = 12.5%, so double = 25%
Year 1: $24,000 × 25% = $6,000
Year 2: $18,000 × 25% = $4,500
Year 3: $13,500 x 25% = $3,375 and so on
Sum-of-the-Years’ Digits Method: Accelerates depreciation using fractions. It is based on the total number of years against the depreciable amount ($22,000 for this example).
Formula: (Years Remaining ÷ Sum of Years) × Depreciable Amount
Calculation: Sum of 8 years = 1+2+3+4+5+6+7+8 = 36
Year 1: (8 ÷ 36) × ($22,000) = $4,889
Year 2: (7 ÷ 36) × ($22,000) = $4,278
Year 3: (6 ÷ 36) × ($22,000) = $3,667 and so on
Unit-of-Production Method: Based on actual usage rather than time.
Formula: (Cost - Salvage Value) ÷ Total Expected Usage × Actual Usage
Calculation: Expected to bake 200,000 loaves during its useful life = $0.11 per loaf ($22,000 ÷ 200,000).
Year 1: 30,000 loaves = $3,300
Year 2: 18,000 loaves = $1,980
Year 3: 23,000 loaves = $2,530 and so on
Choosing the Right Depreciation Method
The best depreciation method depends on your business strategy, financial goals, and IRS tax rules. Some methods provide higher deductions upfront, while others spread costs evenly over time. A tax professional can help you determine the most tax-efficient approach while ensuring compliance with IRS regulations.
Schedule an appointment with our tax professionals to discover which depreciation method is best for your small business.
Tax Benefits of Depreciation for Small Businesses
Depreciation reduces taxable income, lowering the amount a small business owes in taxes each year. By spreading asset costs over time, businesses can better manage cash flow while still claiming valuable deductions. This tax benefit helps businesses reinvest savings into operations, growth, or new equipment.
What Is the Section 179 Deduction?
Section 179 lets businesses write off the entire cost of eligible depreciable assets in the year they are put into use, providing an immediate tax benefit. It helps small businesses manage cash flow by accelerating deductions for equipment, machinery, software, and certain improvements.
The IRS sets annual limits on the maximum deduction and the total amount of qualifying purchases. Businesses must use the asset for business purposes more than 50% of the time to qualify. Consult a tax professional to maximize this deduction while staying compliant with IRS rules.
Common Mistakes to Avoid When Applying Depreciation
Here are common errors to avoid:
Misclassifying Expenses as Assets: Some purchases, like office supplies, should be expensed, not depreciated. Incorrect classification can inflate asset value and distort your business's financial statements.
Using the Wrong Depreciation Method: Can affect deductions and net income. IRS rules must be followed.
Failing to Track Depreciation: Annual records are required to avoid missed deductions and IRS penalties.
When to Stop Depreciating an Asset
Depreciation ends when one of the following occurs:
The asset reaches the end of its IRS-defined useful life.
The asset is fully depreciated, reaching its salvage value or zero.
The asset is sold, retired, or disposed of before its useful life is complete.
At this point, you remove the asset from your books and adjust any remaining value as a gain or loss.
Optimize Depreciable Assets for Maximum Benefits
Depreciation provides small businesses with a valuable tax benefit by reducing taxable income and enhancing cash flow. Properly classifying assets and choosing the right depreciation method can lead to significant savings, allowing businesses to reinvest in growth and operations. Section 179 offers an additional advantage by allowing businesses to deduct the full cost of qualifying assets in the year they are purchased, providing immediate tax relief.
To fully leverage depreciation and Section 179, it’s essential to consult with a tax professional. They will help you ensure your business complies with IRS rules, maximizes deductions, and avoids common mistakes. With the right approach, depreciation becomes a powerful tool for financial management and long-term success.
