Tax Advice

Make the Most of Your U.S. Business Expenses: What You Need to Know About Depreciation

If you’re just getting started—or even if you’ve been in business for a while—depreciation may be an expense category that you aren’t very familiar with or just don’t understand. Well, it’s time to get familiar because depreciation can lead to valuable income tax deductions that may save you thousands of dollars per year while allowing you to reinvest in your business.

What Is Depreciation?

Depreciation allows you to deduct the cost of big-ticket business assets over the time you use them rather than deducting the cost of the asset in a single year.

For example, say you buy a $2,400 MacBook Pro for your business. Hopefully, that MacBook will last more than one year. So rather than deduct the full cost in the year you buy it, you can allocate a portion of the cost to each of the years you’ll use it in your business.

How is Depreciation Calculated?

In general, there are two methods for applying depreciation to your business: Tax depreciation and book depreciation. Tax depreciation is set by law, while book depreciation can be used for your own accounting purposes.

About Tax Depreciation

Tax depreciation also matches the cost of the asset to the amount of time you will use the asset in your business. For tax purposes, most assets are depreciated using the Modified Accelerated Cost Recovery System (MACRS), which lets you take a larger deduction in the first few years of the asset’s useful life and a smaller write-off later. However, the asset’s useful life depends on the asset class. The most commonly used asset classes for small businesses are:

• Five-year property (computers, office equipment, cars, and light trucks)
• Seven-year property (office furniture and fixtures)

IRS Publication 946 provides detailed tables to help you calculate MACRS depreciation depending on the type of asset you are depreciating. Calculating MACRS is much more complicated than straight-line depreciation, so it’s usually best to leave these calculations to your software or tax preparer.

About Book Depreciation

Book depreciation is a method of depreciation you might use for your own books and records. The goal is to match the cost of an asset with the revenue it helps you earn across its lifetime.

The most common way to depreciate assets for book purposes is the straight-line method. With this method, you take the total cost of the asset and divide it by its useful life. The result is the amount you’ll depreciate each full year until you’ve reached the end of the asset’s useful life.

For example, if you estimate that you’ll use that $2,400 MacBook Pro for five years, for book purposes, you would record depreciation expense of $480 per year ($2,400 ÷ 5).

Which Depreciation Method Is Right for Me?

Some businesses calculate depreciation using both methods, using the straight-line method for their own financial reporting and MACRS for their tax return. But unless you’re required to use a different method for your books than you use for taxes, you may prefer to track depreciation using the method you’ll use on your tax return.

Hold on: How Does Section 179 Come into Play?

You may have heard about Section 179—a method for expensing the full cost of business assets in the year they’re placed in service.

For 2022, the Section 179 deduction allows you to deduct all or a portion of the cost of new and used equipment and off-the-shelf software instead of depreciating it.

You may note the term “placed in service.” This is because you can only claim a Section 179 deduction for an asset in the year you actually start using it in your business, which may be different from the year you bought it.

For example, say you purchased that $2,400 MacBook pro on December 27, 2022, but because of holidays and vacations, didn’t start using it in your business until January 2, 2023. Technically, you wouldn’t be eligible to claim a deduction for that purchase until you file your 2023 tax return because 2023 is the year you placed the MacBook in service.

Your maximum Section 179 deduction can’t be more than your taxable business income for the year, but any unused deduction can be carried forward indefinitely and deducted against your taxable income in future years.

There is also a cap on the amount of Section 179 you can deduct per year. For the 2022 tax year (returns filed in 2023), that cap is $1,080,000. Your deduction is phased out dollar-for-dollar if you purchase more than $2.7 million in property during the year.

Those amounts are indexed for inflation, so they increase every year, but most small businesses should have plenty of opportunities to take advantage of Section 179 expensing without running into those limits.

How Do You Claim Depreciation on Your Business Expenses?

To claim depreciation and a Section 179 expense, you must complete Form 4562 and attach it to your return.

Is There an Easier Way?

Try as we might to simplify depreciation and the Section 179 deduction, these are complex topics that even seasoned tax professionals have trouble remembering sometimes.

Fortunately, there is an easy way to get a tax break when you purchase some assets: The de minimis safe harbor election.

That name sounds complicated, but it’s actually pretty simple. With the de minimis safe harbor election you can immediately write off the cost of certain assets up to $2,500 (more if you have audited financial statements prepared by a CPA).

That option to immediately expense the cost sounds a lot like Section 179, but the de minimis safe harbor election comes with less red tape. For one, there is no limit on the amount you can deduct, because the $2,500 is applied per asset.

So if you bought five MacBook Pros at $2,400 each, you could deduct the full $12,000 as equipment expense—no need to report the MacBooks on Form 4562 and worry about carrying the deduction forward if you don’t have enough business income this year to absorb the full deduction.

Taking advantage of the de minimis safe harbor election is simple, but there are a couple of essential rules you need to follow first.

1. Put a written expensing policy in place BEFORE the year in which you’ll start writing assets off under the de minimis safe harbor rule.

This is as easy as typing up a document that says:

“For tax years beginning in 2021 and forward, {BUSINESS NAME} elects to treat as an expense for both books and income tax purposes property with a cost of $2,500 or less, including items that have a useful life of 12 months or less. It is {BUSINESS NAME}’s intention that this election complies with the IRS Section 1.263(a)-1(f) de minimis safe harbor election.”

Print it, sign and date it, and keep it with your business’s organizational documents.

2. Make sure the de minimis safe harbor election is made on your year-end tax return.
In most tax software, making this election is as simple as checking a box, but the election is annual and must be selected every year.

Most business owners hear the word “depreciation” and run the other way, but it’s something that should definitely be leveraged by small business owners. The calculations can be complex, but if you can get through them—or hire a tax professional to handle them for you—they can increase your tax savings in the years when your business needs it the most.

This post was updated in December 2022.