Depreciation has always been one of the best tax breaks for any business owner. It is sometimes underutilized. It is often under-appreciated for how much it can really save you if you use the rules to your advantage. Depreciation used to provide great tax benefits, now it is even better under current tax laws.
When you own a business, you are able to write off depreciation of certain properties such as real estate or equipment you use in your daily operations. Let’s say you buy a new computer. Technically, you shouldn’t write off its full cost immediately in the first year. You will deduct its depreciation as a business expense over its lifetime—until it is no longer useful to the business. Every type of property and physical asset may be treated differently under IRS rules. You can check out Appendix B on IRS Publication 946 for a complete chart of what they call the Modified Accelerated Cost Recovery System (MACRS).
Some things will depreciate quickly, such as computers, vehicles and office equipment (5 years). Others will depreciate slower, like boats (10 years), land improvement/landscaping (15 years), residential rental property (27.5 years) and commercial rental property (39 years). With rental property, it’s important to know that you can only depreciate the structure, not the land.
How long you depreciate your properties and assets for your tax breaks is up to you. You can use a more accelerated rate of depreciation, which allows you to get your tax benefits quicker. Or, you can use a slower depreciation table to spread out your deductions over the maximum allowed amount of years. It all depends on your situation and when those tax breaks will be most advantageous to you.
The basic formula for depreciation is fairly simple. You take the value of the asset and subtract out its “salvage value.” Then you divide that total by its useful lifespan.
There are different methods you can use to calculate and deduct appreciation:
Straight Line Depreciation—This is the easiest form of depreciation calculations. You will simply divide your adjusted value of the asset by a set number of years. So, in the case of a computer, that would be up to 5 years. Each year, you deduct the same amount of depreciation for that piece of property.
Accelerated Depreciation—This is a bit more complicated, and there are several methods you can use within this accelerated depreciation concept. Rather than spreading out the depreciation deductions evenly, you use a more accelerated table with more deducted early on and less later.
Alternative Depreciation System—This one is the most complex as it actually takes longer than straight line depreciation. It makes sense in certain situations, but you will definitely want to consult with your tax advisor or financial professional to do it properly.
Ultimately, depreciation provides several key tax benefits that allow you to save on taxes between deduction and recapture. Depreciation is also very beneficial when it comes to 1031 exchanges. Under the Tax Cuts and Jobs Act of 2018, depreciation has become even more advantageous to most business owners thanks to Bonus Depreciation and Section 179 Depreciation.
In 2002, you could take 30% depreciation in year one and then divide the rest over the useful life of the property. Bonus Depreciation was raised to 50% in 2003 and then raised to 100% with the TCJA in 2018, which gives business owners much more flexibility in terms of when and how much they can deduct depreciation on various physical assets and rental properties. Some items will have limitations. For example, a vehicle can be depreciated up to $18,000 in the first year. The new laws also allow you to buy used property and depreciate it just like you would new property.
The following types of property are eligible for bonus depreciation:
The last type of depreciation you need to understand is Section 179 Depreciation. It is similar to bonus depreciation in that it can be taken all in the first year rather than spread out over multiple tax years. Under current tax laws, it is limited to $1 million and reduced dollar-for-dollar by amounts of over $2.5 million. Section 179 Depreciation is extremely beneficial for certain properties and business equipment.
So what qualifies for Section 179 Depreciation?
This basically includes work vehicles over 6,000 pounds and a majority of business and office equipment such as computers, software, office furniture, building improvements, etc. It does not include rental property or intangibles like patents and trademarks. Leased property can qualify for Section 179 Depreciation under certain very strict and specific circumstances.
As you can see, there are a lot of great things that you can benefit from when it comes to depreciation, whether it’s standard straight line depreciation, bonus depreciation or Section 179 Depreciation. It’s important to understand the tax laws and how they affect your business. Use the tax laws to your advantage by making the most of your depreciation.
For help with your business tax planning and depreciation review, contact Illumination Wealth today to schedule an introductory consultation with one of our top financial advisors.