A lot of accounting for small businesses is straightforward. Most people who run a business understand how to keep track of cash, accounts receivable, and the like. Depreciation, though, is a concept that trips people up.
Depreciation is the accounting term for how, for financial statements and tax, the cost of a long-lived asset is deducted from income. For this purpose, a long-lived asset is generally something that is not acquired for resale and is expected to be in use for more than a year. By default, these assets can’t be written off up front, but have to be expensed over a period of time.
The Internal Revenue Code and the IRS specify a life for most kinds of fixed assets. Here’s a quick rundown of some common items:
5 years - computers, vehicles, appliances
7 years - office furniture, anything that doesn’t have another life specified
15 years - land improvements such as fencing, driveways, parking lots; interior improvements to existing real estate
27.5 years - residential real estate
39 years - nonresidential real estate
Land cannot be depreciated, and the cost of land is only recovered at sale.
Real estate assets are depreciated equally (on a monthly basis) over their full life. Non real estate assets are typically depreciated on an accelerated basis, where a disproportionate amount is deducted in the initial couple of years.
Under current law, any asset with a life less than 20 years is eligible for what’s known as “bonus” depreciation. This is an up front amount that can be written off in the initial year of the asset’s life, similarly to how it would be treated if the asset were expensed. Right now, any asset that’s eligible can be 100% expensed by bonus depreciation - so typically, we’re only depreciating real estate by traditional methods.
Additionally, any taxpayer can make an election to expense all tangible items (not for resale) that cost less than $2,500 each; all they have to do is make sure their accounting records are consistent with this.
This article is compressing several hours of a college accounting course down to less than 400 words, but hopefully it helps you understand a little bit of how we save you tax dollars on your big purchases!