Depreciation is an income tax deduction that allows you to recover the cost of assets like cars, furniture, and equipment that you purchase and use in your business. Depreciation can also be reported for accounting purposes so that your financial statements accurately reflect your investment in fixed assets. Generally, any fixed asset–a long term asset that can’t easily be converted to cash–can be depreciated. This includes intangible property such as patents and software.
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In this article, we will discuss the following:
- How Depreciation Works
- What Requirements Must be Met to Depreciate Assets
- When Depreciation Starts and Ends
- The 6 Depreciation Methods & Which One You Should Use
- How To Claim the Tax Deduction for Depreciation
- How To Record Depreciation for Accounting Purposes
- How QuickBooks Helps Calculate Depreciation
How Depreciation Works
There are two ways that you can use depreciation, as a tax deduction and as an expense that you record on your books for accounting purposes. Let’s look at each in more detail.
1. Using Depreciation to Get a Tax Deduction
Taxes are what most people think of when they hear the word depreciation. The IRS generally does not allow you to take a deduction for any fixed assets that you purchased all at once. For example, if you purchase a $1 million dollar crane, you can’t deduct the entire $1 million dollars in the same year that you purchased it. Instead, you would have to depreciate the crane over its expected lifetime and deduct a portion of the cost each year.
There are three primary methods that the IRS lets you use to determine the allowable tax deduction for fixed assets:
- MACRS, which stands for Modified Accelerated Cost Recovery System – This is the primary method of depreciation that the IRS lets you use to determine the allowable tax deduction for fixed assets. In general, with MACRS, you can write off more depreciation in the early years of an asset and less in the later years.
- Straight line depreciation – If you have intangible assets that you need to depreciate like patents or computer software then you would use straight line depreciation and not MACRS to calculate your tax deduction.
- Section 179 deduction – If your asset qualifies for Section 179, then you can deduct up to $500,000 in fixed assets in the year of purchase. This lets you receive the entire tax deduction up front; you don’t have to spread out the cost over a number of years.
Section 179 example
Let’s assume that our $1 million crane qualifies for the Section 179 deduction. That would allow us to write off 50% of the cost of the crane ($500,000) in the first year, assuming that we did not purchase any other fixed assets. The remaining balance of $500,000 would be depreciated using the MACRS depreciation method. Find out more about Section 179 and your potential tax savings with our Section 179 calculator.
We’ll discuss each of these depreciation methods in more detail later in the article.
2. Reporting Depreciation for Accounting Purposes
If you are on the cash basis of accounting like most small businesses, then you don’t need to depreciate fixed assets for your books (although you would still need to depreciate for tax purposes). That being said, if you purchase multiple assets for your business or a very expensive asset, it can throw off your books if you don’t use depreciation.
Let’s go back to our $1 million crane example. Below, I have provided you with revenue and expense totals on a sample profit and loss statement. Let’s assume that before we purchased the crane we have revenue of $300,000 and expenses of $125,000. That will give us a net profit of $175,000. In the second example, we have purchased the crane and decided to go ahead and expense the entire cost of $1 million (instead of using depreciation). When we do that, our expenses go up by 1 million dollars and we are left with a loss of $625,000. Now our profit and loss statement shows a loss of $625,000 instead of a surplus of $175,000.
|Profit and Loss Statement (Before Crane)||Profit and Loss Statement (After Crane; Depreciation Not Used)|
From an actual cash position, nothing has changed. Whether or not you depreciate, you have still spent $1 million on the crane. However, the $625,000 loss shown on the profit and loss statement fails to account for the fact that you’ll likely be using the crane for years to come. Had we used depreciation, our reported expenses for the crane would have been much lower, and we would have wound up with a surplus (or a much smaller loss) on our profit & loss statement.
In our example, failing to depreciate the crane over the years that it will be used took us from showing a healthy profit ($175,000) to showing a substantial loss ($625,000). If you intend to qualify for a business loan or attract investors, you do not want to present financial statements that will give the impression that your business is not doing well (when it really is). This is one of the benefits of recording depreciation for fixed assets over a period of time.
There are 4 methods of depreciation that you can use for accounting purposes that meet Generally Accepted Accounting Principles (GAAP) guidelines: Straight Line, Double Declining Balance, Sum of the Years Digits, and Units of Production. Read on to learn more about these depreciation methods.
The crane example that we’ve referred to a few times now illustrates that a business’ financial statements serve a different purpose from tax returns. For taxes, all I generally care about is taking the largest deduction I can up front so that I can reduce my taxable income. For my books, I want to be able to show a realistic and accurate bottom line for myself, investors, and lenders.
As a result, it is acceptable to calculate depreciation for taxes differently from how we record depreciation for accounting purposes. This also means that it is possible for your books to differ from what is reported on your tax return. As a result, many businesses keep two sets of books: tax-adjusted basis for tax purposes and book-adjusted basis for accounting purposes.
- Tax-adjusted basis – The set of books you keep for tax purposes is used to calculate the deduction you can take for fixed assets on your tax return. As we discussed at the beginning of this article, depending on the type of asset, tax-adjusted basis is calculated by using the MACRS depreciation method, straight line depreciation, or Section 179.
- Book-adjusted basis – This set of books reflects what an asset is worth from a business’ internal perspective. The book-adjusted basis is calculated using one of the four methods of depreciation mentioned previously which we will go into greater detail later in this article (straight line, double declining balance, sum of the years digits, or units of production).
To reiterate, most businesses only care about the tax adjusted basis and how they can use depreciation to enjoy a tax deduction. But if you purchase expensive assets or multiple assets in a year, then you may want to record depreciation for your books as well.
If you are a little worried about calculating depreciation right on your own, a virtual bookkeeping service like SmartBooks could be a big help. They have a team of accountants and bookkeepers that can help you figure out the best method for calculating depreciation. They have years of experience helping small business owners maximize their tax deductions. Get your first consultation free.
Now that we’ve covered the basics of how depreciation works for both tax and book purposes, let’s delve a bit more into what assets are eligible for depreciation.
What Requirements Must be Met to Depreciate Assets?
1. The asset must be depreciable
Below is a summary table with a list of assets that can and cannot be depreciated for both tax (the IRS rules) and book purposes (Generally Accepted Accounting Principles, GAAP):
Summary Table of Fixed Assets
|Assets that can be depreciated||Assets that cannot be depreciated|
|Vehicles: cars, taxis, buses, trucks|
Office equipment: computers, monitors, printers, copiers
Appliances, carpet, furniture used to furnish residential rental property
Office furniture: desks, filing cabinets
Home office space: a room or a portion of your home that is used for business
Buildings: factory or warehouse
Major repairs: any kind of improvement that restores an asset and adds value (i.e. roof replacement on a building)
Intangible assets: patents, computer software
Leased or rented property: office space, factory, warehouse
Minor repairs to an asset: repairs made for normal wear and tear like tire replacement or oil change on a car
2. You must own the asset
You are considered the owner of property whether you paid cash for it or assumed a mortgage or loan to secure the property. For example, let’s say you purchased a vehicle so that you could become an Uber/Lyft driver. You will be making payments on the car for the next 5 years. You are considered the owner of the vehicle, and you can depreciate it. You can also depreciate leased property if it meets certain requirements. Refer to IRS Pub 946 for additional information on how to depreciate leased property.
3. The asset must be used in your business
You cannot depreciate property used solely for personal reasons. However, you can depreciate property that is used for both business and personal reasons. The allowable deduction that you can take will be limited to the amount of time the asset is used for business purposes.
For example, when you’re not driving your Uber clients around, you are running errands and taking your kids to school. Your depreciation deduction for the car will be based on the percentage of time you use your car to drive your Uber clients around (business) and not the time you spend running personal errands. In this particular situation, it is best to have a mileage tracker that will allow you to easily separate business and personal trips. Check out our Best Mileage Tracker App buyer’s guide to learn more.
4. The asset must have a determinable useful life
This means that the property must wear out, become obsolete, or lose its value in order to be depreciated. Certain types of property, like land, don’t wear out and are therefore not eligible for depreciation.
5. The useful life of the asset must be greater than one year
The property must not become obsolete or lose all of its value within the first 12 months. If the asset will not last for more than one year then you can generally expense it at one time and you do not have to depreciate it.
How Do I Treat Repairs and Improvements?
Over the years you may find that you need to make repairs or improvements to a fixed asset. It’s important to distinguish the difference between an improvement and a repair since an improvement is depreciable and a repair is not.
Let’s say that you own a warehouse and you have a minor leak in the roof that needs to be repaired. The cost to repair the leaky roof can be expensed 100%. However, if you have a major leak in the roof that requires you to completely replace it then this roof replacement is considered an improvement because it restores the property and adds value. The new roof should be set up as a fixed asset and depreciated over its useful life.
When Does Depreciation Start and End?
Knowing when depreciation starts and stops is important because it is a key component when it comes to calculating the allowable tax deduction that you can take. Depreciation starts when you place your property in service for use in your business. Depreciation stops when you have either fully recovered your cost or when you retire the asset from service, whichever happens first. We’ll explain what all of this means with a few examples.
Placed in Service
You place property in service when it is available and ready for use in your business. Even if you are not using the property, it is in service when it is ready and available for its intended use. Here is an example to demonstrate how this works.
On March 30, you bought a duplex to use as residential rental property. You had to make several repairs to the property to get it ready for renters. On June 1 all of the repairs were complete, and the duplex was ready to rent. You begin to advertise it on Craigslist and in the local paper. The first tenants move in on July 1. However, the duplex is considered to be placed in service on June 1 when it was ready and available for rent.
Cost Fully Recovered
Depreciation stops when you have fully recovered your cost in the asset or if you stop using it for business, whichever comes first. For example, let’s say you purchased a computer for $5,000 (including purchase price, delivery fees, and other associated costs). Let’s assume the computer has a useful life of 5 years and that you will deduct $1,000 per year as depreciation expense. In this scenario, the cost of the computer will be fully recovered in the 5th year. Therefore, the computer is no longer eligible for depreciation at the end of year 5 as indicated in the table below.
Summary Table of Cost Fully Recovered for a Computer with a 5 Year Useful Life
|Year||Depreciation Expense||Ending Balance
(Cost less depreciation expense)
Retired From Service
You stop depreciating property when you retire it from service, even if you have not fully recovered the cost. This may occur because any of the following have taken place:
- You sell or exchange the property.
- You convert the property to personal use.
- You abandon the property.
- You transfer the property to a supplies or scrap account.
- The property is destroyed or damaged and no longer usable.
The 6 Depreciation Methods & Which One You Should Use
The summary table below provides a brief description of each depreciation method and whether it is used for book or tax purposes.
Summary Table of Depreciation Methods
|Depreciation Method||Description||Books or Tax|
|Section 179||The Section 179 deduction allows you to deduct up to $500,000 in depreciation expense for fixed assets. To see if you qualify, check out our Section 179 calculator.||Tax|
|MACRS||This method is only used for income tax purposes and allows you to write off more depreciation in the earlier years of an asset’s useful life. Check out How to Calculate MACRS Depreciation to learn more.||Tax|
|Straight Line||This depreciation method can be used for book or tax purposes. When used for taxes, it’s primarily for intangible assets like software and patents. This method spreads the cost of the asset evenly over its useful life. Check out How to calculate Straight Line Depreciation to learn more.||Books or Tax|
|Sum of the Years Digits (SYD)||This depreciation method allows you to write off more depreciation expenses in the earlier years and less depreciation in later years. Check out How to Calculate Sum of the Years Digits Depreciation to learn more.||Books|
|Double Declining Balance (DDB)||This depreciation method allows you to write off even more depreciation expenses in the earlier years than sum of the years digits. Check out How to Calculate Double Declining Balance Depreciation to learn more.||Books|
|Units of Production (UOP)||This method was designed specifically for manufacturing environments. It calculates depreciation based on the number of units that a fixed asset produced in a year. Check out How to Calculate Units of Production Depreciation to learn more.||Books|
Let’s look at how these depreciation methods work and how to choose which one to use by walking through an example.
Sample Depreciation Expenses for $1000 Computer Using Different Depreciation Methods
(5 yr useful life)
Choosing a Method for Tax Purposes
In my opinion, the most important depreciation methods are the ones that determine your tax deduction–MACRS, Section 179, and Straight Line. For this example, we wouldn’t be able to use straight line depreciation to calculate our tax deduction since that’s reserved for intangible property like software and copyrights.
In the chart above, MACRS yields a tax deduction of $240 in the first year and $384 in the second year. If you qualified for Section 179, then you could deduct the full $1,000 cost of the computer in the first year.
While it is important for you to understand the different depreciation methods and how they work, I recommend that you save yourself some time and leave depreciation calculation to the experts. If you do your own taxes, use TurboTax. It is our recommended tax software for small businesses, and it will calculate your depreciation tax deduction for you!
Choosing a Method for Book Purposes
For most small businesses who are not in the manufacturing business, Straight Line is the most popular method used for book purposes because of how simple it is to calculate depreciation. Once you calculate the depreciation for the first year of an asset, it is the same each year. This is demonstrated in the above chart. Depreciation for the first two years of the computer is $200 per year and will remain at $200 for the remaining 3 years. The other benefit of using straight line is that it will show a consistent depreciation amount year over year which will result in more accurate financial statements.
When it comes to deciding which depreciation method you should use for book purposes, there are several factors that come into play.
If you manufacture a product, then go with Units of Production. Under this method, depreciation is calculated based on the number of units produced by the machine or equipment used to make your product. So, it will be the most accurate.
If you have assets that lose their value within the first couple of years after purchase like a car or a laptop computer, then you may opt for Double Declining Balance or the Sum of the Years Digits method since both of them will result in a higher depreciation expense earlier on in the life of the asset.
How Do You Claim a Tax Deduction for Depreciation?
As we have discussed, MACRS, straight line, and Section 179 are the primary deprecation methods for tax purposes. No matter which method you use, to claim your tax deduction, you must complete Form 4562 for each asset that you want to claim a deduction for. This form should be filed with your tax return. To learn more about MACRS depreciation, check out our article How to Calculate MACRS Depreciation.
If you made a mistake in calculating depreciation on a prior year tax return, you can file an amended tax return to make the correction. However, depending on the type of mistake you may be required to file Form 3115 in addition to an amended return. Some examples of common errors made are: if you used the wrong MACRS table to calculate depreciation, if you depreciated an asset that should not have been depreciated (refer to above table of what can and cannot be depreciated), or if you need to adjust the useful life of an asset.
How Do you Record Depreciation for Accounting Purposes?
For accounting purposes, I recommend you record depreciation on a monthly basis. This is how often you should be reviewing your financial statements like your Profit and Loss Statement and Balance Sheet reports.
To record depreciation for accounting purposes, you will create a journal entry. But first, make sure you have set up a depreciation expense account and an accumulated depreciation account on your chart of accounts. To learn more about how to set up a chart of accounts list, read on to the Can QuickBooks Help Me to Calculate Depreciation section.
The journal entry will be a debit to the depreciation expenses account, which will increase total expenses on the profit and loss statement. The credit will be to the accumulated depreciation account. This account will appear on the balance sheet report to reduce the net value of all fixed assets. Here is the journal entry that should be recorded using the straight line method for year 1 of our computer example above:
In addition to recording depreciation on the books, you need to create a depreciation schedule that includes detailed information about each fixed asset. If you have accounting software like QuickBooks Online, then creating this schedule is a piece of cake. However, if you don’t have accounting software, then I suggest you use a spreadsheet program. Here is an example of what information your depreciation schedule should include:
Sample Depreciation Schedule: 7-Year Property
|Date Put in Service||Description||Cost||Recovery Period (years)||Depreciation Year 1 (Books)||Depreciation Year 1 (Tax)|
Can QuickBooks Help Me Calculate Depreciation?
You can manage all of your day to day business transactions in QuickBooks, but it will not calculate depreciation for you. If you’re interested, there are fixed asset software programs that will help you to keep track all of your fixed assets and calculate depreciation for you.
While QuickBooks does not calculate depreciation, you can still use it to track your fixed asset purchases, create depreciation schedules, and record your depreciation expense.
As we discussed in the previous section, the first thing you will need to do is set up your fixed assets on your chart of accounts list. Below is a screenshot of the new account set up window in QuickBooks along with a brief description of what info you need to complete the setup. To learn how to set up the chart of accounts in QuickBooks, check out our How to Set Up the Chart of Accounts video tutorial.
- Category Type: Select Fixed Assets
- Detail Type: Select the type of fixed asset you want to set up (i.e. Vehicles).
- Name: Enter the name of the asset
- Description: Enter the same info as the name field or provide any additional info about the asset in this field.
- Original cost/as of date: Enter the original cost of the asset and the date of purchase.
- Depreciation/as of date: Enter any accumulated depreciation that you may have already taken.
Tip: You will only complete this field if you started depreciating the asset prior to setting it up in QuickBooks.
After you have created the fixed asset in QuickBooks, run a chart of accounts report and filter it to show just fixed assets. Here is a snapshot of this report:
Export this report to Excel, add the additional info that we discussed that should be included on your depreciation schedules, and save it.
If you are in the market for a new accounting software, be sure to check out our free QuickBooks Online course. QuickBooks will allow you to easily create journal entries to record depreciation expense for all of your fixed assets. With QuickBooks, you can also track detailed information for your fixed assets so that you can quickly create depreciation schedules.
The Bottom Line
Before you read this article, you probably knew that you could take depreciation as a tax deduction but maybe you were not as familiar with how depreciation works for book purposes.. By now, you should have a better understanding of what type of property is depreciable, what types of depreciation methods are used for your books and what is acceptable for tax purposes, and the impact that depreciation expense has on your financial statements.
If you are still uncertain about how to accurately report depreciation, you can consult the experts at SmartBooks. All SmartBooks customers are assigned a dedicated member of the accounting team who will provide expert advice on how to calculate and report on depreciation. Get your first consultation free.