Understanding how Depreciation Works: Here’s the Big Picture

Depreciation can be complicated. Fortunately, it is simpler than it used to be.

There are still many complex rules that can prove mind-numbing for anyone but a tax professional. Is the asset 3-year property, 5-year property, 7-year property or maybe as much as 39-year property? How do you understand those unusual descriptions of depreciation methods, like straight-line and double-declining-balance?

Then, there are rules stating, if you use a declining-balance method, you can switch to the straight-line method at the optimal time. How do you know when the optimal time has arrived?

There are hundreds of pages of complex rules that are impossible for the average business owner to keep up with—that is, if you want to have time to run your business.

The best approach is to not to get bogged down with the technical rules. Instead, focus on the big picture. Tax depreciation doesn’t need to be intimidating – and it’s important to your cash flow.

Here is the big picture: The government will effectively pay for a portion of the cost of the assets you acquire to use in your business. This payment comes to you through a reduction in the taxes you pay over one or more years after you purchase the assets.

The portion of the cost of an asset that is paid by the government depends on your marginal tax rate. If you are in a 25 percent marginal tax bracket, the government pays 25 cents for every dollar you spend on machinery, equipment, desks, chairs, vehicles, buildings, etc.

If your marginal tax rate is 35 percent, the government pays 35 cents for every dollar you spend on these assets. This is the one – and maybe only – situation in which being in a higher tax bracket actually benefits you.

This only works, however, if your business is profitable or you have another source of income that a business loss can offset. Spending $1,000 on something you can’t use just to save $350, means you are throwing away $650 you could have held onto.

Years ago, everything had to be depreciated evenly over the assets “useful life.” So, if the asset had a 7-year useful life, 1/7^th the cost would be deducted each year until the 7 years were up. These rules were later modified to “accelerate” the deduction for the asset by taking a higher-than-average deduction in the earlier years and a lower deduction in the later years.

Over time, additional rules were developed that allow deducting assets in full the first year. Unless your marginal tax rate changes from year to year, your total tax savings will be the same, regardless of how quickly you take the deduction. But it is usually better to get your deduction sooner rather than later, as you can reinvest the tax savings back into your business.

Current tax law gives several options for how quickly these deductions can be obtained. Listing them out in detail is beyond the scope of this article, but the following general guidelines can be useful:

• Personal Property can be depreciated in full the year it is placed in service
• Residential Real Property must be depreciated straight-line over 27.5 years
• Commercial Real property must be depreciated straight-line over 39 years
• Depreciation for Luxury Automobiles is capped at $19,200 in the first year, with the rest expensed over following years
• Automobiles over 6000lbs gross weight are not subject to the Luxury Automobile cap and can generally be depreciated in full the first year.

Savvy business owners make decisions about the acquisition of fixed assets by considering factors outside of the cost of the asset alone. They also factor in the after-tax cost by considering both the amount and the timing of any resulting tax savings.

As with all things tax, whether the general rules apply depend on the facts and circumstances of your particular situation. Be sure to consult with a tax professional to get the most benefit out of your fixed asset purchases. For any questions related to this article, contact Zak Carter at zcarter@vlcpa.com or 800.887.0437.