Nearly every business asset, from machinery to office equipment, inevitably faces obsolescence. Technology advances, operational needs change, and items wear out, requiring continual investments in the very items necessary to run your business. Fortunately, the tax code recognizes this economic reality, offering tax breaks for depreciation.
But there’s more than one way to account for depreciation, and understanding how to leverage various depreciation methods can maximize your tax savings – transforming a simple accounting practice into a strategic advantage.
Depreciation basics
Put simply, depreciation is a way for businesses to account for the loss of value that occurs over time with capital assets. As long as the expense helps your business make money and you will use it for a year or more, you can likely depreciate it. But there are rules about what is depreciable. For example, inventory, land, and assets held for investment can’t be depreciated.
Certain assets, due to their short useful life or low cost, are directly expensed rather than depreciated. If the asset doesn’t deteriorate over time, like land, or is relatively liquid, like inventory, it’s not depreciable.
The Modified Accelerated Cost Recovery System (MACRS) is the default method of depreciation for most assets under the tax code. It accelerates depreciation, providing larger deductions in the earlier years of an asset’s lifespan. However, businesses have the flexibility to choose other methods to maximize their tax savings.
Accounting for depreciation
There are several ways to deduct depreciable assets, each with its own rules and benefits. However, once a depreciation method is applied, you are generally required to stick with that method for the duration of the asset’s life.
The Section 179 deduction enables businesses to expense the cost of qualifying assets immediately, but there are limitations. Likewise, bonus depreciation allows businesses to deduct most of the cost of an asset in the first year, according to a set percentage. And, there are other less commonly used methods to calculate depreciation based on different formulas.
Section 179 deduction
The Section 179 deduction isn’t really a method of calculating depreciation. Rather, it allows businesses to immediately expense up to $1.22 million of the purchase price of qualifying assets (as of 2024). Qualifying property includes tangible assets such as computer software, equipment, and machinery. Certain improvements to non-residential real estate, such as roofs, HVAC, security, and fire protection systems, also qualify. However, it generally cannot be taken on rental properties.
Vehicles used more than 50% for business purposes are eligible for the Section 179 deduction, but the deduction amount can vary significantly based on the type and usage of the vehicle. For instance, the deduction for vehicles weighing less than 6,000 lbs. is capped at $19,200, and vehicles weighing 6,000-14,000 lbs. are capped at $30,500. Heavy vehicles above 14,000 lbs. can potentially qualify for the full deduction amount up to the $1.22 million limit.
The deduction begins to phase out dollar-for-dollar once total asset purchases exceed $3.05 million. If, for instance, you placed $3.10 million of assets in service this year, the deductible amount would be reduced by $50,000, so you could only deduct $1.17 million instead of the full $1.22 million.
Additionally, Section 179 cannot be used to create or increase a net operating loss. This means the deduction is limited to the amount of taxable income, and losses can’t be carried forward to future tax years.
Bonus depreciation
Bonus depreciation is another way to write off the majority of an asset’s cost upfront. In 2024, businesses can deduct 60% of the cost of qualifying assets without any upper limits. However, bonus depreciation is phasing out by 20% annually and will phase out entirely by the end of 2026 unless new legislation extends it.
Unlike Section 179, bonus depreciation can be used to create a net operating loss and can also be carried forward. Better yet, businesses can use Section 179 and bonus depreciation in the same year. On each individual asset, Section 179 must be applied first to expense all or a portion of the cost basis, before applying bonus depreciation to the balance. If the business is operating near a loss, Section 179 can only be used to reduce taxable income to zero. Any remaining cost can then be addressed with bonus depreciation, potentially creating a loss that offers tax savings in future years.
For example, consider a business that purchases $500,000 in qualifying property but only has $100,000 in taxable income for the year. Using Section 179, the business can immediately expense $100,000, reducing its taxable income to zero. Bonus depreciation can be applied to the remaining $400,000 resulting in a loss that can be carried forward to offset taxable income in the future.
However, these deductions must be used judiciously to avoid “double-dipping” or claiming more than one type of depreciation for the same dollar spent on an asset.
Other depreciation methods
While Section 179 and bonus depreciation are popular for their ability to offer substantial tax cuts upfront, several other methods are available that calculate the rate of depreciation differently. These methods generally offer varying rates of acceleration, differing primarily in the timing and size of the deductions. Straight-line depreciation, however, is distinctive for its simplicity and predictability.
This method spreads the cost of an asset evenly across its useful life and is the only option available for depreciating intangible assets like patents or copyrights. And, unlike accelerated depreciation methods, it reduces the risk of depreciation recapture. This occurs when an asset is sold for a price higher than its depreciated value, which can result in the IRS “recapturing” some of the accelerated depreciation benefits previously claimed. This recapture is taxed as ordinary income. With the straight-line method, the asset’s book value decreases at a slower, more consistent rate, more closely aligning with its actual market value over time.
Choosing the best option
The best choice for your business will depend on several factors, including your total investment in depreciable assets, current income, and future income projections.
Here are a few scenarios to show each strategy in action:
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Section 179. A business purchases $500,000 in new machinery. Profits are substantial and stable. Section 179 will allow the business to expense the entire amount in the first year, providing immediate tax relief that can be reinvested into the business quickly.
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Bonus depreciation. A startup in its early stages expects to ramp up its earnings significantly over the next few years. It invests $2 million in high-tech equipment. Using bonus depreciation enables the startup to deduct 60% (or $1.2 million) of the investment immediately, even if it creates a loss. That loss can be carried forward to offset taxable income in future profitable years. The remaining 40% of the assets’ cost can also be depreciated over time.
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Straight-line depreciation. A business acquires vehicles, intellectual property, and equipment totaling $100,000. The company enjoys moderate, stable income but has minimal tax liabilities for the current year. They’re also unsure how long they will keep the vehicles before reselling. Straight-line depreciation can be applied to the IP assets and ensures the company benefits from predictable tax relief in the future when tax liabilities may be greater. It also reduces the risk of recapture if the company decides to sell the vehicles within the next few years.
Best practices
Effective management of depreciation not only impacts your tax obligations but also plays a crucial role in optimizing cash flow. Here are a few best practices applicable across all depreciation methods that can enhance your financial strategy:
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Time your purchases. If you anticipate tax liabilities as you approach the end of the fiscal year, consider acquiring necessary assets during this period. This approach allows you to claim deductions for the full year, even if the asset was only in service for a short time.
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Reinvest early savings. Initial savings from accelerated depreciation or Section 179 should be reinvested into the business. This can fuel growth and prepare the business for future periods when tax liabilities may increase.
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Leverage technology. Consider purchasing or working with professionals who use software to track depreciation schedules. This can ensure accuracy and save time and resources.
Consult with tax professionals
While seemingly simple, depreciation involves complexities that are best navigated with professional guidance. Our expert advisors can tailor your depreciation strategy to maximize tax benefits based on your specific business needs.
If you’d like to learn more, please contact our office. We’ll help you turn depreciation into a strategic advantage while staying compliant with evolving regulations.
