Well, friends, we made it to tax day! I’m sure many of my tax prep colleagues are headed out for some well-deserved vacation days right about now - as they should be. There is no particular reason tax season needs to be so painful, but - here we are. Many people wait until the deadline is looming to pull their records together, and it’s stressful for all involved.
One major reason that it’s stressful is that it sometimes feels like roulette - spin the wheel and find out how much you owe Uncle Sam. Wouldn't it be easier to do the planning during the year so you have a good idea going in what your liability will be?
Yes, it would be! I agree!
Since we’re talking taxes, I thought I would address a tax topic that affects most business owners but the strategy of which is less commonly understood. I’m talking about depreciation.
Now, one of the reasons depreciation is often overlooked as a strategy is that it has a lot of rules and calculations - aaaand I can see your eyes glazing over now! But it's a powerful tool that can reduce your tax liability and boost your profitability.
💰 The coolest part is that depreciation is an “expense” on your profit and loss (income) statement but there is no cash out of your pocket. So it actually reduces your net income and therefore your tax bill -saving you money.
First of all - What is depreciation?
Depreciation is the fancy accounting word for the way an asset decreases in value over time and how the tax code allows you to recover the cost. That’s it. It can be a short time or a long time, and the factors vary based on the usage of the asset - like wear and tear or obsolescence.
(The Internal Revenue Service dedicated an entire publication to it here.)
There are multiple ways to calculate depreciation, and this is where strategy comes into play.
Straight-line Depreciation - Is basically taking the purchase price of the asset minus the expected salvage value and dividing it by the number of years it is expected to have a useful life. In the simplest possible terms: buy a $50,000 truck, plan to use it for 5 years, and sell it for $20,000. $50,000 - $20,000 = $30,000 / 5 years = a depreciation deduction of $6,000 per year.
Accelerated Depreciation - aka MACRS (Modified Accelerated Cost Recovery System,) in which the asset is depreciated according to a standardized asset class schedule determined by the IRS (see the above-linked publication.) The system has multiple choices and allows a faster recovery period than standard straight-line. You can elect to take larger depreciation in the earlier years of the asset life and smaller depreciation in the later years. The method chosen should match the type of asset and the savings objective.
Units of production depreciation - Allocates the expense based on the actual usage of the asset. This makes the most sense for a high-usage asset such as a machine in a manufacturing facility. This is extremely helpful in cases where you know how many units the machine is capable of producing rather than the number of years the machine will last. In high-volume production, the machine will wear out in relation to the output, not the calendar.
Bonus Depreciation - also commonly known as Section 179. This rule allows a business to claim all the depreciation on an asset in the first year it is placed in service. (Subject to a dollar limit which is $1,160,000 in 2023) This is a common tax reduction strategy, but it is not always the wisest. For one thing, if you sell the asset, you must recapture (reverse) any depreciation above the standard allowance anyway - so you’ve just undone your tax benefit. Another consideration worth noting is that, hopefully, your profit is increasing over the years, and you’ll potentially jump into a higher tax bracket. That depreciation could be more useful to bring your taxable income down in later years than it is to you now.
Just like depreciation is a reduction to your taxable income, it is also a reduction to what’s known as the book value of your asset. Book value is the purchase price and associated costs to place an asset in service, MINUS depreciation. It's the value of the asset on your books. This value frequently does not reflect the property's actual value (the price you could get on the open market,) so don't worry if it doesn't seem to match your expectation.
When planning your tax strategy, it’s important to reflect on your overall business strategy, and consider how this affects your balance sheet as well. When used thoughtfully, your depreciation strategy can have long-term benefits for your bottom line.
REMEMBER - For analysis of your specific situation; please consult with an expert!
OK, so now we understand depreciation. In part 2, I’ll discuss how this applies to the business use of a vehicle.
My dedication is one asset that never depreciates!
And I appreciate you,