Most businesses require non-current assets in order to operate and generate income. These assets are referred to as property, plant and equipment (PP&E). PP&E are depreciable assets and can be used as tax breaks over time, to lower your company’s taxable income year to year.
Construction companies, for example, need heavy duty machinery and motor vehicles such as trucks. A real estate company would require residential property and office space. Non-current assets come in all forms. What they all have in common is that they can be depreciated over time.
Qualifying assets must meet these requirements to be depreciable:
- It must be property owned by the business or owner of the business
- It must be used for income producing activities
- It must have a determinable use life (useful life)
- It must last more than one year
The reason for depreciating an asset over time is to use the depreciation expense to counter the net income brought in by the business. So, If you had a net income of $100,000 after expenses but had a depreciation expense of $25,000, you would only have a taxable income of $75,000.
Once the assets is depreciated fully, it has a zero book value. Whatever it is sold for would be considered capital gains.
A multitude of assets can be depreciated over time as long as they meet the criteria above. Each type of asset has a different useful life. A useful life refers to the rules established by the IRS which allow you to depreciate an asset over a certain amount of years. Using real estate as an example, it’s useful life is up to 27.5 years. So when you buy a property, it can be depreciated over that amount of time.
We’ve mentioned the power of real estate regarding to its tax advantage in our previous post How Owning a Home is a Tax Break and Investment, All in One. Real estate not only has tax advantages for individuals, but also for businesses. The fact that you can depreciate an asset on the books that potentially goes up in market value over time has great advantages from an investment perspective.
Real estate has a useful life determined by the IRS of 27.5 years. This is an odd number of years, but never the less is the maximum amount of years you can depreciate real estate.
To be clear, depreciation for real estate is regarding property with a building on it. Raw land cannot be depreciated because it does not go down in value besides in market price.
Each year that your property incurs a depreciation expense, that expense can be deducted from your rental income (or whatever income your business brings in) to lower your taxable income for the year.
Another strategy for depreciating real estate is by using a cost segregation method which takes individual pieces of the property like appliances, HVAC units and so forth, and depreciates each asset individually over time. This strategy can be complicated, and we recommend you speak to a professional about it.
Other depreciable assets include vehicles, heavy equipment, machinery, and office equipment. Each type of asset has its own individual useful life generally decided by the IRS.
Methods of Depreciation
There are multiple methods to depreciate an asset, but we are only going to cover two of the main methods.
The straightline method of asset depreciation is the most commonly used by businesses because it is predictable year to year.
This method just involves determining an assets useful life, then taking its paid for value and dividing it over the useful life. So, if you had an asset valued at 100,000 and its useful live was 7 years, this asset would depreciate on the books by $14,285 each year.
The upside to the straighline method is that it gives the business a simple and forward method to expense their assets’ depreciation. This also gives them the same depreciation expense each year, making expenses more balanced year to year.
The accelerated method is used mostly for heavy equipment and vehicles because they are most heavily used at the beginning of their life, giving them the most wear and tear during that time period. The accelerated method has two sub-methods within it: double-declining and sum-of-the-years-digits. For the sake of simplicity we will focus on double-declining.
For double declining, you must take the assets useful life and turn it into a fraction. Let’s use 5 years as our example. So we have a fraction of 1/5. You then take the percentage that the fraction creates which is 20%. You then double that percentage and get 40%. You depreciate the book value of the asset by 40% each year until you get to the final year, where you have the option of depreciating the final amount of book value.
Depreciation expensing can be used by your business on a multitude of assets. Each asset has a certain useful life that you need to be aware of. There are multiple methods of depreciation like straighline and double-declining that you can use. It is important to decide a method that works best for your business. Using depreciation as a tool to give your business a tax break is a crucial component to maximizing your deductions.
If you’re a business owner with assets and you want to explore your strategies to depreciate those assets, visit our contact page and get in touch with us.