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With tax season just around the corner, many people will talk with their CPAs and tax planners to see if any last-minute changes should be made to minimize the tax bill for their businesses and to achieve the most favorable tax situation at year end.
If you own a business, “depreciation” and “amortization” are words that may come up during that conversation. While most people have a basic understanding of depreciation, amortization is a bit more confusing. It’s similar to depreciation, and it works like depreciation…but it’s used for different kinds of business assets.
Confused? You aren’t alone. In this article, we break down the basics for you.
What is Depreciation?
Depreciation is the reduction in value of a tangible asset with the passage of time, usually to account for wear and tear. It spreads the cost of an asset over a specified period of time, typically the asset’s useful life, and is used to match the expense of obtaining an asset to the income that asset helps your business earn.
Depreciation takes the value of that asset and expenses it over a given period of time. For example, if you buy three new computers for the office totaling $4,500 they would be depreciated over a five-year period.
What Is Amortization?
Amortization is the cost allocation of an intangible asset over time.
Can you spot the key difference between amortization and depreciation? Depreciation is used for tangible assets whereas amortization is used for intangible assets.
Intangible assets are non-physical assets that are essential to your business. Customer relationships, contracts, franchises, patents, and licenses are all examples of intangible assets—they’re business assets that have no material substance but that add value to your business.
When amortizing an asset, the goal is to match the expense of acquiring that asset with the revenue that asset generates.
As a basic rule-of-thumb, you depreciate tangible assets and amortize intangible assets.
What Should I Depreciate and What Should I Expense?
When you meet with your CPA, be sure to ask how they want you to determine whether an asset should be capitalized and depreciated versus expensed. Ask if they have filed or plan to file a de minimis safe harbor election form with your timely filed tax return.
The safe harbor allows taxpayers to set a capitalization threshold so all amounts that fall below that number are not capitalized for federal tax reporting purposes. This election allows you to expense tangible assets that are less than $2,500 per invoice or item, thus eliminating the burden of deciding whether or not you should depreciate or expense a given asset.
If there are certain assets that are less than $2,500 and that qualify for the de minimis safe harbor election, you don’t necessarily need to expense them! You can still use depreciation to spread the cost of that asset out over a given period of time. This will be useful for planning in certain years where you don’t need any additional expenses to have no taxable liability at year end. There are many nuances and regulations regarding this—be sure to reach out to us or your CPA to discuss the details.
Any tangible assets over the safe harbor limit and certain types of intangible assets will still need to be capitalized and depreciated per IRS regulations.
Methods of Depreciation
Straight line depreciation, which spreads the cost of an item evenly over its useful life, is probably the easiest to understand. You simply take the asset’s value and divide it by its recovery period or useful life. For example, if you purchase a machine for $20,000 that you’ll use for 5 years, the cost would be written off as $4,000 for each year the machine is used.
When you amortize an intangible asset, you will most likely use the straight line method.
MACRS (modified accelerated cost recovery system) is the most widely used method on your taxes. This method allows you to take a larger deduction in the earlier years of the asset and less of a deduction in the later years.
The formula to calculate MACRS depreciation is simple: Cost basis of the asset X Depreciation rate
While the formula is simple, actually calculating MACRS is difficult because the depreciation rate used varies depending on the type of asset you are depreciating. It is therefore typically in your best interest to let your tax software or your tax professional do the calculations for you.
To add more variables to the mix, the IRS allows you to depreciate 100% of the cost of an asset through bonus depreciation in the first year on qualifying new assets. This is a temporary increase from 50% in prior years. This is known as a Section 179 deduction and is used to incentivize business owners to buy equipment, new and used but new to the owner, and invest in their businesses.
For 2018 the maximum allowed depreciation under Section 179 of the tax code is $1,000,000 on up to $2.5 million in purchases. If you surpass this $2.5 million threshold, the deduction is limited dollar-for-dollar until phased out at $3.5 million in purchases. This phase-out limits the deduction to small and medium sized businesses.
What Recordkeeping is Needed?
Just as for all expenses, you need to keep receipts for any asset purchases. Any contracts and title documents should also be kept.
For your personal records, keep track of all assets purchased for your business in a spreadsheet. Include information such as the date of purchase, a description of the asset, and its cost. You’ll also want to keep track of the depreciable (useful) life of the asset and the accumulated depreciation on that spreadsheet. Likely, your CPA is tracking this for you and can give you their asset list if requested.
Understanding depreciation and amortization is not easy and is most often best left to the professionals. Actually calculating depreciation gets even trickier. IRS Publication 946 outlining all the details is hundreds of pages long—not exactly something we would expect you to read.
Hopefully you now have at the very least a basic understanding of a few general depreciation topics so you can have a productive conversation with your CPA and develop a tax planning strategy that includes depreciation and amortization to maximize tax savings for your business.
Looking for more guidance? With a full-time CPA on staff, we are here to help. Reach out to us to discuss your personal tax situation.