One of the nice things about having your own business is that you can deduct the money you spend for items you use to make money in your business, such as computers, vehicles, office equipment and furniture. You can take a full deduction whether you pay cash for an asset or buy on credit.
Depreciation involves deducting the cost of a business asset a little at a time over a period of years, rather than deducting the entire cost in a single year. Whether you must depreciate an item depends on how long it can reasonably be expected to last, which the IRS calls its “useful life.”
Depreciation is used to deduct the cost of any asset you buy for your business that has a useful life of more than one year, such as buildings, equipment, machinery, patents, trademarks, copyrights, and furniture. Land cannot be depreciated because it doesn’t wear out. The IRS, not you, decides the useful life of your assets for tax purposes.
If you use property for both business and personal purposes, you can take depreciation only for the business use of the asset.
Example: Carl uses his photocopier 75 percent of the time for personal reasons and 25 percent for business. He can depreciate 25 percent of the cost of the copier.
The depreciation period begins when you start using the asset in your business and lasts for the entire estimated useful life of the asset. The tax code has assigned an estimated useful life for all types of business assets, ranging from three to 39 years. Most of the assets you buy for your business will probably have an estimated useful life of five to seven years. You are free to continue using property after its estimated useful life expires, but you can’t deduct any more depreciation.
There are several different systems you can use to calculate depreciation. Most tangible property, however, is depreciated using the Modified Accelerated Cost Recovery System (MACRS). A slightly different system, the Alternative Depreciation System, or ADS, applies to depreciation of specified “listed property,” property used outside the United States, and certain farm and imported property.
Under MACRS, there are three different methods you can use to calculate your depreciation deduction: the straight-line (SL) method or one of two accelerated-depreciation methods. Once you choose your method, you’re stuck with it for the entire life of the asset.
In addition, you must use the same method for all property of the same kind purchased during the year. For example, if you use the straight-line method to depreciate a computer, you must use that method to depreciate all other computers you purchase for your business during that year.
The straight-line method requires you to deduct an equal amount each year over the useful life of an asset. You ordinarily deduct only a half-year’s worth of depreciation in the first year. You make up for this by adding an extra year of depreciation at the end.
Example: Sally purchases a $1,000 computer in 2014 that she uses solely for business. It has a useful life of five years. Using the straight-line method, she would depreciate the asset for over six years. Her annual depreciation deductions are as follows:
Accelerated and double declining-balance depreciation methods
However, most small businesses use accelerated depreciation. The advantage is that it provides larger depreciation deductions in the earlier years and smaller ones later on. The double declining-balance method starts out by giving you double the deduction you’d get for the first full year with the straight-line method.
Example: Sally purchases a $1,000 computer in 2014 that she uses solely for business and decides to use the fastest accelerated-depreciation method to depreciate it: the double declining-balance method. Her annual depreciation deductions are as follows:
The IRS imposes special rules on certain items that can easily be used for personal as well as business purposes. These items, called “listed property,” include:
- Cars, boats, airplanes, and other vehicles
- Computers, and
- Any other property generally used for entertainment, recreation, or amusement (including photographic, communication, and video recording equipment).
The IRS fears that taxpayers might use listed property items for personal reasons but claim business deductions for them. For this reason, you’re required to document your business use of listed property. You can satisfy this requirement by keeping a logbook showing when and how the property is used.
You normally have to document your use of listed property even if you use it 100 percent for business. However, there is an exception to this rule: If you use a computer only for business and keep it at your business location, you need not comply with the record-keeping requirement. This includes a computer you keep at your home office if the office qualifies for the home office deduction.
If you use listed property for business more than 50 percent of the time, you can depreciate it just like any other property. However, if you use it half or less of the time for business, you must use the straight-line depreciation method and an especially long recovery period. If you start out using accelerated depreciation and your business use drops to 50 percent or less, you have to switch to the straight-line method and pay taxes on the benefits of the prior years of accelerated depreciation.
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MileIQ’s blog does not constitute professional tax advice. You should contact your own tax professional to discuss your situation.