Mar 14, 2023
How does depreciation work for entrepreneurs?
- The things we buy decrease in value over time, and calculating that decrease is known as “depreciation.”
- Business owners can use depreciation calculations to qualify for tax deductions.
- Assets that you own and use to make money or run your business — even part-time — can be depreciated to lower your taxable income.
We all try to appreciate what we have, whether it's the people in our lives, the place we call home, or the stuff we own. We try our best to take care of our belongings and keep them looking and feeling new, but eventually we have to replace some of them. Stuff gets old. Some things break or get worn out, and some become outdated by new technology.
This happens in our personal lives, but it also affects business owners. Business owners and even employees can spend big bucks buying the newest and best tools (like the latest laptop and tech) to keep up with their competitors, but over time, those tools become outdated and lose value.
The process of depreciation — which is used for accounting and tax purposes — can help business owners deal with that loss of value. Depreciation reduces the amount of taxes they pay by allowing for tax deductions.
So, how does depreciation work? We’ll give you a guide to the basics of depreciation and how it can help you manage your money.
How does depreciation work?
Depreciation is the decrease in value of something you’ve bought as it ages over a period of time. That definition looks simple, but it can be a complicated concept. Let’s look at an example.
Let’s say you’ve decided to launch your own YouTube channel, but you need better equipment to make high-quality videos. You’ll probably want to buy lighting, a good microphone, and editing software. You might even spring for a top-of-the-line computer.
These purchases are all considered tangible assets, which is a term for the things you buy in order to run your business. Assets can be anything from machinery to licenses to the building your business is located in, but in this case, your assets would be your software, lighting, microphone, and computer.
You might have already thought about what those things will cost to buy, but depreciation is about how their value will decrease from what you pay to get them. As time goes on, your assets will be worth less than their new price. That loss of value is depreciation.
Understanding depreciation and how it works can help business owners reduce the taxable income they report on their tax returns with the IRS. Going back to the example of buying a new computer for your YouTube channel, you can receive an income tax deduction for the purchase price (or the cost of the asset). With depreciation, that deduction is split up across multiple tax years, giving you tax savings for those years.
What can you depreciate?
If your business is new, understanding how depreciation works with your taxes starts with knowing what items you can depreciate. The property you depreciate should meet these IRS requirements:
You have to own it.
You have to use it in your business or to make income.
It must have a useful life, and it has to be expected to last longer than one year.
So, the new computer, lighting, and recording equipment you buy for your YouTube channel are depreciable assets. Your editing software might be, too, because some intangible assets (software, patents, and licenses) can be depreciated if they’re used in your business.
But what about property you’re still paying off, or assets you sometimes use for personal reasons? Let’s take a closer look at what you can depreciate.
Depreciation of property that you own
Keeping your receipts is more than good life advice — it’s key to making your taxes easy to manage. You can depreciate assets that you own, and it helps to have what the IRS calls “incidents of ownership” to prove it. These could be purchase receipts, legal titles, or the legal obligation to pay for or maintain the property.
It could also include your financial risk if the property is damaged, destroyed, or devalued.
You’ll most likely need financing to purchase some assets for your business, like real estate or vehicles. But you can depreciate these assets even while you’re still paying for them because you’ll have a deed or title that proves you own them. Just remember that you can depreciate buildings or office space but not land itself.
Depreciating assets you use part-time
Another common concern is how to depreciate assets that you use part-time for your business. Don’t worry, even side-hustlers can get depreciation tax deductions! If you use your car to make deliveries on the weekends or split your computer between running your YouTube channel and doing your schoolwork, you can depreciate those assets based on the time you use them for your business.
That means you can’t simply depreciate your computer over five years if you’re only using it for your business 75% of the time. Instead, you would calculate the total depreciation amount and multiply it by 0.75 to get the amount that matches your use of it.
This also applies to some home offices. So if you’re working from home in a spare bedroom (or even a spare corner), you may be able to depreciate it. IRS Publication 587 has more details on how to know if your office space qualifies.
The useful life of depreciable assets
The useful life is the number of years that an asset will be used. It’s essentially the asset’s lifespan. Keep in mind that this is an estimate and other factors besides age can affect the value of an item, like a new model or wear and tear. For an asset to be depreciable, you or your accountant need to be able to determine its useful life, and it needs to last longer than one year.
For tax purposes, the useful life of the asset is how long you can write off the asset on your tax return. According to the IRS, you can write off residential rental properties for 27.5 years, and computers, vehicles, appliances, and office equipment can be written off for up to five years.
This means that your YouTube business assets will likely be depreciable for five years. But if you buy a business course or textbook, you won’t be able to get a depreciation tax deduction for it because the IRS considers its useful life to be less than one year. Instead, you can write it off as a business expense.
How depreciation of business assets is calculated
If you’re navigating how to pay taxes as a small business owner, you should talk to a tax professional about preparing and filing your taxes. If you’re curious about how depreciation is calculated, here’s a simple overview.
Depreciation calculation starts with the purchase price of the asset and its useful life. The type of asset will determine how long it’s eligible to be written off. In other words, how many years you’re able to get a tax deduction for it.
Many of the assets you might buy when you start a small business or side hustle at home will have a five-year useful life. That means if you upgrade from your kitchen table to a home office, you can write off the furniture and technology you buy for up to five years.
Once you know the useful life of the asset and its initial cost, you can use one of several methods of depreciation calculation to figure out how much you can report each tax year, including two accelerated depreciation methods.
But the straight-line method is the simplest type of depreciation calculation. Subtract the salvage value from the initial cost of an asset, then divide the result by the number of years in its useful life. This will tell you the annual depreciation that you can deduct from your taxes each year.
The salvage value of an asset is the estimated value it will have at the end of its useful life. This comes into play if you plan to sell the asset when you’re done with it. According to CFI, “Typically, companies set a salvage value of zero on assets that are used for a long time, are relatively inexpensive, or if the technology becomes obsolete quickly.”
Here’s an example of straight-line depreciation in action. Let’s say you want to buy studio lighting for your YouTube channel:
Cost of the asset: $600
Salvage value: $0
Useful life: Five years
Based on these figures, you can depreciate the $600 over five years. When you divide the $600 by five, you find that your annual depreciation is $120, which is a depreciation rate of 20%.
If you’re interested in learning about other methods of depreciation, check out the accelerated cost recovery system (ACRS) and the modified accelerated cost recovery system (MACRS). There’s also the declining balance method for assets that quickly lose value, like technology, and the units of production method.
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If you’re a small business owner, or if you plan on starting your own business, depreciation can help you save money and grow your business by lowering your taxable income with tax deductions. There are many ways to calculate depreciation, depending on the assets and your financial goals.
But even if you don’t have a business to run, depreciation is a useful topic. When you understand how much and how quickly an item depreciates, you can make informed decisions about when to buy an item, plan for how long you’ll be able to use it, and even budget and save for a future replacement.
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