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Understanding how Depreciation Works: Here’s the Big Picture

4/12/16

Depreciation is complicated.

It is probably one of the more difficult tax concepts for business owners to understand. There are many complex rules that can prove quite elusive for anyone but a tax aficionado.

The best approach is to try not to get bogged down with the technical rules and instead focus on the big picture. Tax depreciation need not be so intimidating. And it’s important to your cash flow.

Here is the big picture: The result of all those complex depreciation calculations is that the government will pay for a portion of the cost of the assets you acquire to use in your business. That payment comes to you through a reduction in the taxes you pay over one or more years after you purchase the assets.

Of course, to really obtain a tax benefit from the depreciation deductions, either your business must be profitable, or you must have another source of income that your business losses can offset.

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 percent of the cost of your machinery, equipment, desks, chairs, vehicles, buildings or whatever fixed assets you buy for your business.

If your marginal tax rate is 35 percent, the government pays 35 percent of the cost of those assets. This area is one – and maybe the only – situation in which being in a higher tax bracket actually benefits you.

All of the rules about useful life can be mystifying. 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 the rules tell you that, 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?

Fortunately, the IRS publishes tables that simplify the depreciation calculations. And most accounting software for your business comes with a depreciation program included or available as an add-on.

Here is the bottom line on depreciation life and method: As noted above, your marginal tax rate determines the portion of the cost of your business asset that the government will subsidize by letting you pay less tax. The life and method applied to the asset determines when the government will provide the tax savings to you.

So the shorter the life, or number of years over which you claim the depreciation deductions, the sooner you obtain your tax savings. And the more rapid your depreciation deductions – declining-balance methods give you greater depreciation deductions for the assets you use in your business than straight-line during the early years – the sooner you will obtain your tax benefit.

Unless your marginal tax rate changes from year to year, your total tax savings will be the same, regardless of the depreciable life or depreciation method. But, of course, there can be a significant economic benefit from obtaining your tax savings sooner rather than later – you can reinvest the tax savings back into your business.

So shorter lives and faster methods generally enhance the cash flow of your business. In the theater that is politics, there is much talk about tax changes to stimulate business activity. In most cases, and the current political rhetoric is no exception, much of the so-called business stimulus results from modifications to the tax depreciation rules.

These modifications generally take two forms:

  • Allowing smaller businesses to deduct immediately, rather than depreciate, the cost of certain asset purchases 
  • Allowing businesses a “bonus” depreciation deduction in the year an asset is first placed in service

Neither of these techniques results in a greater amount of tax depreciation deductions for your business. You can still deduct no more than the total cost of the asset.

The true effect of the stimulus is to increase your tax deduction in the year you acquire the asset by accelerating deductions that would normally be available only in later years.

Accelerated deductions are a good deal for your business. Everyone would rather pay taxes later rather than sooner. But you should not mistakenly equate an acceleration of deductions with, say, a lowering of overall tax rates.

Savvy business owners make decisions about the acquisition of fixed assets by not just considering the cost of the asset. They also factor in the after-tax cost by considering both the amount and the timing of any resulting tax savings.