Every year when tax season rolls around, we tend to see an increase in all of the usual tax jargon being thrown around like carrybacks, deferrals, or depreciation. Let’s face it – taxes are complicated and, as a business owner, chances are good that you’re not an expert when it comes to tax law, so all of these buzz words can start to make your head spin. If you’ve got a great accountant or CPA, they can make short work of your taxes, sparing you from pages and pages of technical instructions and IRS forms A-Z.
That said, it’s also important for you to understand some of the basics. You trust your accountant to help with your finances the same way you trust a mechanic to work on your car. But that doesn’t mean you should never learn how to change a tire. So today, we’re going to take a look at a big, often misunderstood tax term – depreciation.
What Is Depreciation?
Depreciation is, very simply, the deduction of lost value over time. For example, a new car is a depreciating asset – the moment you drive it off the lot (rendering it “used”), its value goes down significantly. And every mile you put on it lowers the value even further. If that car belongs to your company, you can count that depreciation as a business expense and deduct it from your taxes.
We’ll have a more detailed example next, but first we have to establish some basics.
How Do I Calculate Depreciation?
There are numerous ways to calculate the depreciation of your business assets, all with different advantages and disadvantages as they relate to your tax situation. For example, accelerated depreciation allows you to deduct more depreciation up front, saving you more on your taxes in year one than in year five (as an example).
The most common method of calculating depreciation is the “straight line” method. This requires us to know three things about an asset: the initial cost, the life expectancy (the “useful life”), and the amount that asset could be sold for at the end of its lifespan (the “salvage value”). To calculate the depreciation then, you would take the total cost of the asset – the initial cost minus the salvage value – and divide it by the useful life. The total from this formula is the amount you can depreciate each year over the course of the item’s useful life.
One important note – the initial cost of the item includes ALL related expenses, such as sales tax, shipping and handling, installation, etc.
So let’s get back to concrete examples. Your company purchases a computer system for $4000 and pays an additional $1000 for sales tax, shipping and installation. The useful life of this system is expected to be five years. At the end of the five years, you’d expect to be able to sell the system for $1000. So here is your depreciation formula:
$5000 (initial cost) – $1000 (salvage value) = $4000 (total cost)
$4000/5 years (useful life) = $800 per year
With this example, using the “straight line” method, you would have a depreciation deduction of $800 each year for five years.
Why Does Depreciation Matter?
Depreciation matters for two reasons. First and foremost, it is an opportunity to save additional money on your tax bill over the years, allowing you to write off a greater total business expense to levy against your total business income.
The second reason is a little more complex – depreciation is calculated to determine the loss in value of a business’ fixed assets over time. That means that, over time, your business’ total worth (income + assets) declines. When valuing your company – whether it’s for financing purposes or to sell part or all of the company’s ownership – it’s important to know the total value of the business. This includes any and all assets that the business owns, and their current value.
Hopefully this article helps you understand the basics of depreciation a little better – but make no mistake, this is a complicated topic and is best handled as part of your relationship with your accountant. As your financial expert, your accountant can help you keep track of the value of all your business assets over their lifetime, and make sure that your deductions (including depreciation) are lined up in the way that most benefits you.