Small businesses everywhere can get a financial leg up every year thanks to tax savings via depreciation and IRS form 4562. According to this article by NerdWallet, depreciation is the wear and tear that reduces the value of an asset over time and the process by which a business writes off the cost of a capital asset. The IRS outlines what’s depreciable – it includes buildings, machinery, equipment, office furniture, work vehicles, and even patents and copyrights in some cases. Property that can’t depreciate includes land, inventory, and leased property.
By depreciating your equipment, you can help offset your purchase costs with tax savings. How does it work? You depreciate an asset over time and actually get to choose the method you want to use. Depending on your business structure and preference, there might be one method that suits your situation best. Here, we’ll cover the three most common methods that most small businesses use to declare depreciation.
Straight-Line Depreciation Method
This is one of the most common and easiest to learn methods of depreciation because you can take the “same amount of depreciation each year over the useful life of the property,” according to an online article on the Houston Chronicle’s Small Business page. According to financial empowerment website TheBalance.com, “to calculate the straight line depreciation method, you need to take the purchase price or acquisition cost of an asset, then subtract the salvage value at the time it is retired, sold or disposed of. Then, you divide this figure by the total product years the asset can reasonably be expected to benefit the company.”
For all the mathematically-inclined learners out there, writing it out as an equation looks like this:
Straight Line Depreciation = (Purchase Price of Asset – Approximate Salvage Value) ÷ Estimated Life Span of Asset
Now, it’s time to see this method in action. Let’s say one of your expensive sewing machines was originally purchased for $10,000. You know you can get a salvage value of $1,000 for it and these machines usually last for about five years. By taking the amount of depreciation and dividing it by its five year life span, you’ll take $1,800 of depreciation each year for the five years it’s usable.
Double-Declining Balance Method
This is the first of two accelerated depreciation methods that are commonly used. According to this article from The Balance, “accelerated depreciation methods allow a firm to take greater charges against earnings in the early years following the acquisition of an asset with lower charges later on so earnings are hit more heavily in the near-term.” This means this type of depreciation results in heavier depreciation initially. It’s then followed by smaller amounts of depreciation later under the assumption that most assets lose a hefty majority of their value shortly after being acquired rather than evenly over their lives.
There are two versions of the double declining balance method – the 150% version and the 200% version – and you get to choose which one to use to when depreciating your property. Let’s use the 200% version and our $10,000 sewing machine as an example. We already know it’ll be worth $1,000 at the end of its useful life of five years, making the depreciation value $9,000.
Using the straight-line method, we found that our depreciation expense is $1,800 per year. Now, according to The Balance, we take the would-be depreciation expense and figure out what it is as a percentage of the amount subject to depreciation. To find this we simply take $1,800 and divide it into $9,000, giving us .2 or 20%.
Percentage of the Amount Subject to Depreciation = Depreciation Expense Per Year ÷ Total Depreciation
Since we’re using the 200% method, we’re going to multiply 200% by 20% (our percentage of the amount subject to depreciation) to get 40%, which looks like this: 2 x .2 = .4 or 40%
Now, we apply this higher depreciation rate to the carrying value of the asset at the beginning of each year. This means for year one, we will take 40% multiplied by $10,000 to arrive at a depreciation expense of $4,000. The ending carrying value of the year will be $6,000. In year two, we will take 40% multiplied by $6,000 to find a depreciation expense of $2,400 and a carrying value for the year of $3,600. Year three gives us a depreciation expense of $1,440 for a $2,160 carrying value. We’ll see an $864 depreciation value in year four with a carrying value of $1,296 into the final year. In year five, it’ll depreciate until it reaches its final salvage value of $1,000. To use the 150% method, you’ll simply take your percentage of the amount subject to depreciation and multiply it by 150% (or 1.5) instead of 200%.
The Sum of Years Method
Much like the double-declining balance method, this approach results in heavier depreciation and bigger deductions initially. With this option, you will multiply the value of the property by a fraction to find the amount of depreciation for the year. According to this article by The Balance, this is called the “applicable percentage.” To do this, first we need to take the expected life of an asset in years, count backwards to one, then add the figures together. For example, for our sewing machine with an expected five-year lifespan, you would add 5, 4, 3, 2, and 1 together to get 15.
Once again, here’s what the math looks like:
5 years of useful life = 5 + 4 + 3 + 2 + 1
Sum of digits = 15
So, we’ve found our fraction’s denominator - the sum of the years the item will be usable. To find the numerator, the Houston Chronicle article we mentioned earlier states using “the year of ownership.” So this means for a piece of property with a five-year use life, you would use five as the numerator in year one. In our scenario, this would make the asset value subject to depreciation expense 5/15 (or 1/3 which is equal to 33.3%) in the first year. In the second year, the fraction then becomes 4/15 (26.7%), followed by 3/15 (20%) the following year. This continues until the asset is fully depreciated.
Which is Right for Your Business?
Depreciation can lead to valuable income tax deductions that can save small business owners thousands each year. Filling out IRS form 4562 with your tax return decreases your tax burden, since you are lowering your overall taxable income. It’s wise to choose your depreciation method based on the tax implications each method would have. If you would rather have a bigger tax deduction now, you might choose to use the double-declining balance method or the sum of years method. If you would rather spread out your tax deduction evenly, straight-line depreciation may be your best bet. For more information on any of these methods, check out Principles of Accounting’s website, TheBalance.com or AccountingTools.com to learn more.
Looking for more money managing tips? Check out this article, The Business of Breaking Even: How to Calculate your Small Business’s Break-Even Analysis.