Tax Depreciation

Peter VanderWoude, MS, CPA, CGMA

July 1, 2019

This month’s topic is very important to business people and makes an enormous impact on income taxes owed now and in the future. Let’s avoid the details and instead go over the broader concepts about depreciation.

Any asset used by a business, such as a machine, vehicle or building, experiences a decline in value through usage and the passage of time. That reduction in value is called depreciation and is recorded as an expense in financial statements and income tax returns.

How depreciation expense is computed differs widely depending on when and where it is recorded.

In financial statements, depreciation expense, called book depreciation, is generally recorded evenly over an asset’s useful life. For example, Annie recently purchased a $50,000 machine for her business that is expected to last for ten years under normal use. In her books, Annie will record depreciation expense of $5,000 per year for 10 years using what is called the straight line method of depreciation.

For Annie’s income tax return, her tax advisor explains that she can use the straight line method, but she has options to accelerate her tax depreciation expense. In fact, this tax depreciation under current tax law can be as much as 100 percent of the cost of her new machine in the first year. An additional $45,000 of expense on her tax return will save Annie $18,000 in taxes at her combined self employment, federal and state income tax rate of forty percent. That is huge for Annie and she can use that money to grow her business or bring more money home for personal use.

Now you must be thinking, “what about next year’s tax return?” Yes, if nothing changes, Annie will owe $2,000 more in taxes than if she just used the $5,000 per year straight line depreciation. The government eventually gets their tax money, but they will get it over 10 years, where Annie got her tax savings up front in the first year.

Tax depreciation is determined by what accelerated methods are available in the tax law at the time the asset is placed in service. Once placed in service by an owner, an asset’s life and rate of depreciation does not change unless you dispose of the asset before it is fully depreciated. Also, if you sell a depreciable asset at a gain before the end of its useful life, you may have to recapture the accelerated portion of depreciation previously taken as expense and record it as ordinary income instead of the lower taxed capital gain income.

The new tax law has expanded the use of bonus depreciation through 2022, allowing businesses to immediately expense qualified property in its first year. There are many rules and limitations to be aware of when using bonus depreciation.

Be a “rainmaker” for your business. Check with your tax advisor before making major asset purchases. Now, if we can just get this summer’s El Nino rain effect to go away!

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