This is for basic information. Depreciation is a complex subject and it could fill a book. I want to make business owners aware of the theory so that they can plan. Please talk to your tax profession about specifics for your business.
On a trip to the local office supply store, you buy a new color laser printer and a set of replacement cartridges for your business. Since you keep your books up as you go, you add the purchase to your bookkeeping system and plan to use to whole purchase against this years income. The problem is that you really can’t do that. The ink cartridges are current expenses and fully deductible but the printer that has to be depreciated.
Depreciation is required for any asset used in a business (it could be equipment, capital improvements, or software, for example) that has a useful life of over one year and is not inventory. Simply, depreciation does two things. First it allocates the cost of purchase over the life of the asset. The IRS says that the laser printer has a life of 5 years. Divide the cost of the printer by five and that gives you’re the amount that you can depreciate for each year. The second use of depreciation is that it represents the effect of usage on the values of the asset. Say, you buy the new laser printer for $500. That’s the value that time. However, a year later, you could not sell that printer for $500 because of the wear and tear on the asset.
There are also two kinds of depreciation: “Book” and “tax.” “Book” depreciation is used for bookkeeping records and evenly spreads the reduction in value over the life of the asset. Our 5year printer would lose $100 in value each year for 5 years. It could continue to be used but it would not have any impact on the profit and loss of the business. “Tax” depreciation is a creation of the tax code and, for the most part, is considered accelerated deprecation. That is more depreciation is taken in the first years than in the final years. For simplicity, the IRS published the allowed depreciation in charts based on the life of the asset. As if depreciation wasn’t confusing enough, there are several charts of percentages. Your choice will depend many factors such as, when in the year the asset is put into service, if the asset is being used on a farm, are you calculating Alternative Minimum Tax or electing to spread out the depreciation out evenly instead of taking more at the start. To further confuse matters, there are special forms of depreciation that allow even more of the cost to be taken in the first year. Please see your tax profession about what options are available to you.
Are you confused yet?
What do you really need to know? You need to know that some of the things you buy for your business need special treatment. You need to keep track of them separately. But, use some common sense. Yes, the stapler will last more than one year and should be depreciated but that doesn’t mean that it can’t be lumped with other small equipment and depreciated that way. I do that with the off the shelf software and little things like calculators and staplers. The big thing you need to understand that you’re required to depreciate assets on your tax return. But that means that when you sell that asset the gain/loss must reflect the amount of depreciation taken. Let’s say you decide to sell that printer for $250 after you’ve had it for three years. You have taken $300 in depreciation off its value. The math looks like this: $500 original cost minus $300 in depreciation leaves a $200 basis. That is subtracted from the $250 you sell the printer for and you have a $50 gain on the sale. And that is taxable.
Keep track of long term purchases so that they can be treated correctly on your books and tax returns. And ask for help until you get the hang of depreciation.