Depreciation is a business expense applicable to the purchase of capital assets, but it can get a little tricky for owners to work out without getting in trouble with Uncle Sam.
If you buy furniture, equipment, machinery – anything for your business that has a useful life of more than one year, the IRS requires that you write off the expense over the useful life of the asset. But like everything in the tax code, there are some exceptions.
The useful life is basically five years for equipment, vehicles, and machinery; seven years for furniture and fixtures; 15 years for leasehold improvements; and 39 years for commercial property and home offices. To determine the useful life of other assets refer to IRS Publication 946.
Before 1987, depreciating property was a simple matter. There were a few depreciation methods, like straight line in which you divide the cost basis of the asset by its useful life. For example, if you paid $10,000 for a piece of equipment, it would have a useful life of five years.
Divide the cost by five years and your depreciation expense for the year and each subsequent year up to five would be $2,000. But today it’s a bit more complex. There are tables in Publication 946 to assist you in determining how to calculate the amount of depreciation to deduct.
There are special considerations for vehicle depreciation. If the vehicle is not considered “transportation equipment,” like a dump truck or a boom truck – that is, if the vehicle is suitable for personal use and especially if it is used personally – there are special rules.
Since 1987, the IRS has imposed luxury limits for automobiles because it got tired of business owners writing off $200,000 Maseratis. Keep in mind if it’s too much fun, it likely isn’t deductible.
If you bought a new car in 2012 that is 100% business use, you would be allowed to write off a maximum of $11,160 the first year, $5,100 in year two, $3,050 the third and $1,875 for year four and after. If you add up these numbers considering a five-year life, the total is $23,060. If you spend more than that amount on the vehicle, expect to continue taking $1,875 in depreciation until it’s used up. If you did buy a Maserati, you will be depreciating it for quite a while--or replacing it sooner than later.
If you use a vehicle for less than 100% business, you must pro rate the amount of depreciation. If you bought a new car in 2012, and used it, 80% of the time for business and 20% personal, the amount of depreciation you would be able to deduct will be $8,928 ($11,160 x .80).
The depreciation limits for trucks and vans are a little bit higher, and there are special rules if the truck has a gross weight of more than 6,000 pounds. Check with your tax pro for the guidelines.
The exception to standard deprecation that is highly favorable for entrepreneurs is the Section 179 deduction. The premise behind this deduction is the ability to write off the entire purchase in one year.
It is limited when it comes to vehicles and leasehold improvements, but can provide significant savings for taxpayers who must purchase machinery, equipment, furniture and fixtures.
According to the IRS, the maximum section 179 expense deduction that can be elected for qualified section 179 property is $500,000 with a limit on capital purchases of $2 million. Bonus depreciation is also available, and you can deduct 50% of the basis of a purchased asset using this method. For 2012, the limit was $125,000 but with the aversion of the fiscal cliff that limit was also raised to $500,000.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.