What Does Depreciation Mean in Business and How Does It Work?

What Is Depreciation? Definition & How It Works

Lauren Ward

Updated February 19, 2022

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As a small business owner, you likely want to take every business deduction you’re entitled to. One valuable deduction you may not be taking full advantage of is depreciation, which allows business owners to expense a portion of the cost of an expensive asset every year for several years.Depreciation can lead to significant income tax deductions each year. The trouble is that figuring out exactly how to calculate and claim the deduction can be tricky. If you’re a little intimidated by depreciation, read on. Below, we explain how depreciation works and give step-by-step tips for how to calculate depreciation using the most common methods approved by the IRS.

What Is Depreciation?

Businesses are able to take tax deductions on expenses incurred when doing business. For larger business purchases (like a computer, a piece of furniture, a building, a truck, or piece of machinery), however, the expense typically can’t be taken all at once the year you make the purchase. Instead, the cost of the asset is deducted over time through a process called depreciation.Using depreciation, a business can diminish the value of the asset over time and use it as a deductible business expense every year for several years, eventually claiming the full cost.To take a depreciation deduction, you must fill out form 4562 while completing your federal taxes. Recommended: What Are Common Small Business Loan Terms?

How Depreciation Works

The number of years over which you depreciate something is determined by its useful life. A simplified explanation of depreciation is that you take the cost of an asset and then subtract the amount you can expect to sell it for after its expected lifespan has come to an end. From there, you divide that number by its expected lifespan. The resulting number is what you can deduct year to year.You can begin to depreciate the asset once it’s in use, and you stop depreciating it when you’ve fully recovered its cost or you stop using it in your business.

Depreciation Schedule

A depreciation schedule is a table that shows you how much each of your assets will be depreciated over the years. It typically includes the following information:

A description of the asset
Date of purchase
The total price you paid for the asset
Expected useful life
Depreciation method used
Salvage value (how much you can sell it for once it’s past its useful life)

The depreciation schedule of an asset depends on what type of depreciation method you choose. There are several methods from which you can choose.

Depreciating Rental Assets

You can only depreciate rental property if all of the following requirements are met:

The property is used in your business as an income-producing asset.
You’re the owner of the property.
The rental property has a calculable useful life.
The property is expected to last and produce income for more than one year.

You can begin to depreciate the property as soon as it is ready to rent. In most cases you are not allowed to begin depreciating as soon as you purchase it unless it is a turn-key property, meaning it is ready to start bringing in money as soon as it is purchased. However, you don’t have to wait until it is actually rented to begin depreciation. You only have to wait until it is ready to rent. Let’s say you purchase a property in December; repairs last until March, and you’re unable to rent it until July. In this scenario, depreciation can begin as early as March once all of the repairs are finished. While you’re allowed to depreciate the value of a building you’ve purchased, you can’t depreciate the value of the land. Therefore you’ll need to determine what you paid for the land versus what you paid for the building. If that information isn’t available, you can estimate.

Depreciation Recapture

Depreciation recapture happens when you sell an asset for more than you expected it to be worth after a given period of time because of depreciation. For example, say you expected a work truck to only be worth $5,000 after its useful life, but you actually ended up selling it for $10,000. The $5,000 “profit” would have to be reported to the IRS as ordinary income, because in the previous years you counted the truck’s depreciation as an income expense. To properly report the sale of business property, you must use Form 4797 from the IRS.

What Can and Can’t Be Depreciated?

The IRS has rules about what can and cannot be depreciated. Generally for an item to be considered depreciable, it must meet the following three requirements:

It must have a lifespan of one year or more.
You must be the actual owner of the asset.
The asset must be used by your business.

The following table provides examples of what business owners can and cannot depreciate.Keep in mind that if an asset is used for both business and personal purposes, you can't depreciate your personal use of that asset. For example, if you use your car for both business and personal use, you can only depreciate the business-use portion.Recommended: How Do You Categorize Expenses for A Small Business?

How to Calculate Depreciation

Depreciation is determined by one of several methods that have been approved by the IRS. The most straightforward method is straight-line depreciation, but it’s not the only one you can use.Your business might benefit from one depreciation method more than another, and you may not be able to use one method for various reasons, so it can be a good idea to consult with a tax professional to determine which method is the best one for you to use.Here’s a look at six different methods for deducting the cost of a business purchase.

Straight-Line Method

This method allows business owners to depreciate an asset the same amount for each year of the asset’s useful life. Calculating the annual amount is simple: First, determine how much you would get by selling the asset at the end of its useful life (called its salvage value). Subtract that amount from the initial total cost, then divide the difference by the number of years in its useful life.Example: You buy a forklift for $15,000. It has a salvage cost of $1,000 and a five-year lifespan. $15,000 - $1,000= $14,000.$14,000 / 5 years= $2,800. Therefore, $2,800 is the amount you could claim each year as a business expense in this scenario.

Section 179 Deduction

Section 179 allows taxpayers to deduct the entire cost of certain assets the year that they are placed in service. There’s an annual dollar limit on what you can deduct (for example, in 2021 it’s $1,050,000) and you have to be profitable to use the deduction.

Accelerated Method

With the accelerated method, you take out larger deductions early on in the asset’s useful life, and smaller amounts later. This method is commonly used by small businesses.To do the accelerated method, you must use the IRS’s Modified Accelerated Cost Recovery System (MACRS) and use its percentage guide or the alternative depreciation system to calculate how much you can deduct each year for your particular asset.

Double-Declining Balance

The double-declining balance method is another type of accelerated depreciation method that allows you to write off more of an asset’s value in the days immediately after you buy it and less later on. The steps to calculate it are:

Determine the initial cost of the asset (example, $50,000).
Calculate its useful life period (example, 10 years).
Calculate the annual depreciation rate (example, if it’s useful life equals 10 years, then each year the asset will depreciate by 10% each year).
Multiply the initial cost by twice the annual depreciation rate to get the depreciation amount for the first year (example, $50,000 x 20% = $10,000; you can deduct $10,000 this year).
Next, subtract the depreciation amount from the initial value to get the new book value of the asset ($50,000 - $10,000= $40,000).
The next year, multiply the new book value by the double annual depreciation rate tto find out how much to deduct this year ($40,000 x 20% = $8,000; you can deduct 8,000 this year).
Continue doing this until you’ve the book value has reached 0.

Sum-of-the-Year’s-Digits

Sum-of-the-year’s-digits (SYD) depreciation is another method that lets you depreciate more of an asset’s cost in the early years of its useful life and less in the later years. However, with SYD, you end up with a slightly more even distribution than the double-declining balance method allows.To calculate SYD, you add up all of the years (one by one) of the asset’s useful life. If it has a 10-year useful life cycle, for example, that would mean you would be working with a sum, or SYD, of 55 (1+2+3+4+5+6+7+8+9+10=55).To use the SYD depreciation method, you divide the asset’s remaining lifespan by the SYD, then multiply that number by the value of the asset (the cost of the asset minus its salvage value) to get your write-off for the year.This is the formula: (remaining lifespan / SYD) x (asset cost – salvage value)Here’s an example: Say you buy an asset that costs $10,000, has a salvage value of $500, and has a useful life of 10 years. To get the SDY, add up all the digits of 10 (1+2+3+4+5+6+7+8+9+10 = 55).Using the above formula, the first year, your equation will look like this:(10 / 55) x (10,000 – 500) = $1,727You will write off $1,727 the first year. For each year after that, the assets remaining lifespan is reduced by one. So, the second year, your equation looks like this:(9/55) x (10,000 – 500) = $1,555You continue until the entire value is written off.

Units of Production

This is a simple way to depreciate the value of an asset based on how frequently the asset is used. You can use the units of production method to calculate the depreciation of assets like machines, vehicles, and equipment that your business uses extensively over a period of time. This method can be useful for small business owners who want to take more depreciation in years when they use the asset more, and less depreciation when they use the asset less. Because this method requires tracking the use of the equipment, it’s generally only used for high-value equipment or machinery.To depreciate an asset with this method, you need to first determine the item cost (or purchase price) and it’s salvage value. Next, you need to determine the item’s estimated production capability by forecasting how many units or items an asset will likely produce during its useful life (you can do this by doing research into the asset's maximum capacity).Here’s the units of production formula: (asset cost – salvage value) / units produced in useful lifeUsing this formula will give you the dollar value in depreciation for each unit produced. By adding up all the units produced in one year, you can get the amount to write off.Once all of the units have been written off, depreciation of the asset is complete – i.e., its useful life is technically over, and you can’t write off any more units.Here’s an example: Let’s say the machine/asset costs $10,000 and has a salvage value of $500. Its book value is then $9,500.Let’s say that, according to the manufacturer, it can be used to create a total of 100,000 units over its useful life. To get the depreciation cost of each unit, you would divide the book value by the units of production expected from the asset.9,500 / 100,000 = 0.095That means you can depreciate $0.095 per unit. If you produce 12,000 units in the first year, your equation would look like this:12,000 x 0.095 = $1,140You can write off $1,140 of depreciation for the first year. That number will change each year, depending on use.

Comparing Types of Depreciation

Here’s a side-by-side comparison of the different depreciation methods:

Pros and Cons of Depreciating Assets

There are both advantages and drawbacks of depreciating your business assets. Here’s a look at how they compare.

Depreciation Expense vs. Accumulated Depreciation

A depreciation expense is the amount you deduct on your tax return. Since it’s an expense, you record it as a debit.Accumulated depreciation, on the other hand, is the total amount you’ve subtracted from the value of the asset. In other words, it’s the total amount the company has lost on the asset over time. This makes it a “contra asset,” meaning it’s noted on the business’s balance sheet as a negative number.While both terms refer to the accumulated wear and tear of an asset, only a depreciation expense affects what you pay in taxes.

Depreciation vs. Amortization

Both depreciation and amortization are ways to calculate asset value over a period of time. Depreciation is the amount of value an asset has lost over time. Amortization, on the other hand, refers to the decreased cost of an item over a certain period of time.Depreciation is mostly applied to physical assets that wear out over time, whereasamortization is used to depreciate intangible assets (i.e., things you cannot pick up or touch) over their useful life. Here a look at how depreciation and amortization differ:

Depreciation vs. Capitalized Costs

Capitalization involves reporting a large expense on your company's balance sheet rather than on its income statement. This is possible because most large purchases – such as cars or machinery – remain assets owned by the company that could be sold for cash at some later date. Generally, an expense should only be capitalized if its value is retained in the form of an asset.By contrast, depreciation is the practice of expensing the cost of a capitalized asset over time. Many assets cannot be sold later to fully recover their cost but, instead, decline in value over time. The decay in value is predictable and the business reports it as a depreciation expense.

The Takeaway

Depreciation is the process of deducting the total cost of a high-priced item you bought for your business. Instead of doing it all in one tax year, however, you write off parts of it over time. When you depreciate assets, you plan how much money you will write off each year.Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use. There are many types of depreciation, including straight-line and various forms of accelerated depreciation that allows greater depreciation expenses in the early years of the life of an asset.

3 Small Business Loan Tips

If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.
SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.
Traditionally, lenders like to see a business that’s at least two years old when considering a small business loan.

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