Depreciation is a way for businesses to reduce their tax liability each year as they secure equipment and other assets necessary for operations. Overall depreciation encourages spending, especially on new products, so it both helps the business that is making the purchases of needed items as well as helping the manufacturer of that item have sales and recognize profit. This is an example of smart IRS business.
What is Depreciation?
Purchases made for a business will naturally decrease in value over time. Depreciation is the decrease in the value of assets over time due to wear and tear. On the balance sheet of a company, it is calculated as a non-cash expense. This serves to reduce the value of an asset over time. Depreciation is taken as a accounting entry, so cash positions of the business are not affected. This is called a depreciation expense. Aside from wear and tear, another main reason assets are depreciated is because they decrease in value as they are replaced by newer models. This is called obsolescence.
Business items that can be depreciated include machinery, equipment, buildings, technology, office furniture and vehicles. Land is the only item held by a business that cannot be depreciated. Land might be the only asset a business holds that is expected to appreciate over time, and therefore it will subject to depreciation.
How to Calculate Depreciation
Depreciation is calculated by figuring the original cost of the asset. This includes costs of acquiring the asset, transporting it, and any set up that is required. The salvage value is the scrap value of an item. When depreciating an asset, scrap value is taken off the original cost. There is also a “useful life The original cost, less scrap value, divided by the useful life of the asset is considered the depreciation value.
Depreciation is a very valuable tool for businesses. The depreciation values are included in the company’s tax return. These values serve to reduce the businesses taxable income as they are collectively calculated as an expense. Depreciation on a business asset has nothing to do with the way it was purchased. This is important to note because if a business vehicle is purchased using cash or a loan, it does not matter when it comes to depreciating it. If a business takes a loan to finance a vehicle, they can essentially reduce their taxable income through depreciation of an asset they don’t actually own. This only applies to vehicles that are purchased, not leased. Leasing carries its own set of IRS rules.
The Different Methods of Depreciation
The three main types of depreciation methods are straight line, accelerated and declining balance. Straight line and accelerated methods require that the same type of depreciation used in the first year of the purchase of the asset is the same type of depreciation method used until the depreciation period has ended.
What is Straight Line Depreciation?
The straight line method of depreciation is the most often used largely because it is the simplest. This method can be used for any depreciating property. The exceptions are those assets where the IRS requires the use of accelerated depreciation. With straight line, the value of the asset is divided evenly over the asset’s life, and each year the same deduction is taken.
The straight line depreciation formula is the assets depreciable basis less the original cost of purchase. This figure is then divided by the estimated longevity, and this is how the depreciation valued is computed. Under Generally Accepted Accounting Principles (GAAP), this is the most widely used depreciation formula for maintaining internal books of a business. There are also several straight line depreciation calculators online to get a rough idea of an estimated depreciation value for an asset.
This method is called the Accelerated Cost Recovery System (ACRS). This method is for recovering the cost of personal and real property that has shortened useful life. Computers and automobiles are 2 assets that are depreciated using this method. Different properties accelerate at different rates. The Economic Tax Recovery Act of 1981 created this type of depreciation, and it was subsequently modified in 1986. This type of depreciation method was created to encourage businesses to buy assets more frequently. The ultimate goal was to induce spending.
This method of depreciation offers a higher rate of depreciation during the earlier years of an asset’s life. Generally this is reserved for assets that a business will use more than 3 years. This type of depreciation will never fully depreciate an asset, so the IRS allows for a one-time switch to the straight-line method on any asset that is being depreciated using this method. This switch is allowed once in the lifetime of the asset, so as to provide for full depreciation.
What is Accumulated Depreciation?
This is the total amount of depreciation taken on any given asset up to a single point in the life of that asset. Basically this is the amount of depreciation expense taken each year. If $2000 of depreciation is taken each year on asset with a 5-year life, the amount of accumulated depreciation at the end of year 2 would be $4000.
Businesses are largely concerned with depreciation of assets. They are also able to depreciate new vehicle purchases. Individuals, however, are unable to depreciate automobile purchases. A new car generally depreciates anywhere from 15% to 20% in the first year! That is a loss of as much as $8000 on a $40,000 car in just 12 months. That is a very high number. The most an individual normally gets to write off are property taxes paid on vehicle ownership. There is generally a small deduction that is taken on their state income tax.
Individuals who are interested in regularly purchasing new cars should most likely start a small business, so as to effectively manage, and capitalize on, this transaction. Just to get an idea of how much money you can lose by buying a brand new car, consult any one of a number of online car depreciation calculators. These depreciation calculators will help you better understand what happens to your money when you buy a new car.
The IRS was able to induce businesses to spend money on new cars, equipment, and most everything else they need to operate. It was actually a smart policy and it has ostensibly worked out pretty well. Businesses will regularly make moves that are particularly advantageous under the aegis of tax rules. This makes them spend in a way that the IRS is softly encouraging. This is a fine example of the IRS inducing a robust business climate. They made businesses in this country their partner of sorts.