🧾Taxes and Business Strategy Unit 4 – Depreciation & Cost Recovery Basics

What's Depreciation All About?

• Depreciation allows businesses to recover the cost of assets over their useful life
• Helps match the expense of an asset to the revenue it generates
• Reduces taxable income by spreading out the cost of an asset
• Useful life is the period over which an asset is expected to be used to generate income
• Salvage value represents the estimated value of an asset at the end of its useful life
• Depreciation begins when an asset is placed in service and ends when the asset is fully depreciated, sold, or retired
• Different depreciation methods (straight-line, accelerated) can be used depending on the type of asset and business needs

Types of Assets You Can Depreciate

• Tangible assets that are used in a business or held for the production of income can be depreciated
  • Examples include buildings, machinery, equipment, vehicles, and furniture
• Intangible assets such as patents, copyrights, and computer software can also be depreciated
• Land is not depreciable because it does not have a determinable useful life
• Assets must have a useful life of more than one year to be eligible for depreciation
• Leasehold improvements made to a rented property can be depreciated over the shorter of the useful life or the lease term
• Certain assets, such as collectibles and antiques, are not depreciable because they do not have a determinable useful life and may appreciate in value

Methods of Depreciation: Straight-Line vs. Accelerated

• Straight-line depreciation spreads the cost of an asset evenly over its useful life
  • Formula: $(Cost - Salvage Value) / Useful Life$
  • Provides a consistent depreciation expense each year
• Accelerated depreciation methods allow for larger depreciation deductions in the early years of an asset's life
  • Examples include double-declining balance and sum-of-the-years' digits methods
  • Useful for assets that lose value quickly or become obsolete faster (technology, vehicles)
• Modified Accelerated Cost Recovery System (MACRS) is the most common depreciation method used in the U.S.
  • Assigns assets to specific recovery periods (3, 5, 7, 10, 15, 20, 27.5, or 39 years)
  • Uses a combination of accelerated and straight-line methods based on the asset class
• Businesses can choose the depreciation method that best suits their needs and maximizes tax benefits

Section 179 and Bonus Depreciation: The Fast Track

• Section 179 allows businesses to deduct the full cost of qualifying assets in the year they are placed in service
  • Deduction limit for 2021 is $1,050,000 (subject to annual adjustments)
  • Phases out dollar-for-dollar when total asset purchases exceed $2,620,000 (2021 threshold)
• Bonus depreciation allows businesses to deduct a percentage of the cost of qualifying assets in the year they are placed in service
  • 100% bonus depreciation is available for assets placed in service between September 27, 2017, and December 31, 2022
  • Bonus depreciation percentage will phase down starting in 2023 (80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026)
• Both Section 179 and bonus depreciation can provide significant tax savings for businesses by accelerating depreciation deductions
• Qualifying assets include tangible personal property, certain improvements to nonresidential real property, and certain software
• Businesses can use a combination of Section 179 and bonus depreciation to maximize tax benefits

Tax Implications of Depreciation

• Depreciation reduces taxable income by allowing businesses to deduct a portion of an asset's cost each year
• Accelerated depreciation methods and special provisions (Section 179, bonus depreciation) can provide significant tax savings in the early years of an asset's life
• Depreciation recapture may occur when an asset is sold for more than its depreciated value
  • Recaptured depreciation is taxed as ordinary income
  • Applies to assets depreciated under accelerated methods or Section 179
• Depreciation can impact the calculation of self-employment taxes for sole proprietors and partnerships
• Businesses must maintain accurate records of asset purchases, depreciation methods, and accumulated depreciation for tax purposes
• Depreciation can affect a company's financial statements and key ratios (e.g., return on assets, debt-to-equity ratio)

Real-World Examples and Calculations

• Example 1: A business purchases a $50,000 machine with a 5-year useful life and a$5,000 salvage value. Using straight-line depreciation, the annual depreciation expense would be: ($50,000 - $5,000) / 5 years = $9,000 per year
• Example 2: A company buys a $100,000 delivery truck and uses the Section 179 deduction. If the company has taxable income of$200,000 and a tax rate of 21%, the tax savings would be: $$$100,000 * 21% = $21,000$$
• Example 3: A business acquires a $200,000 piece of equipment and uses the MACRS 7-year property class. The depreciation percentages for the first three years would be: 14.29%, 24.49%, and 17.49%, respectively. The depreciation expense for each year would be:
  • Year 1: $200,000 * 14.29$28,580
  • Year 2: $200,000 * 24.49$48,980
  • Year 3: $200,000 * 17.49$34,980

Common Pitfalls and How to Avoid Them

• Failing to maintain accurate records of asset purchases and depreciation
  • Keep detailed records of purchase dates, costs, useful lives, and depreciation methods
• Misclassifying assets or using incorrect depreciation methods
  • Consult with a tax professional or refer to IRS guidelines to ensure proper classification and depreciation
• Not taking advantage of Section 179 or bonus depreciation when eligible
  • Review asset purchases annually to identify opportunities for accelerated depreciation
• Overlooking the impact of depreciation on financial statements and ratios
  • Consider the long-term effects of depreciation on financial metrics and decision-making
• Failing to consider the tax implications of selling depreciated assets
  • Plan for potential depreciation recapture and its impact on taxable income
• Not updating depreciation schedules for changes in tax laws or asset use
  • Stay informed about tax law changes and adjust depreciation strategies accordingly
  • Review asset use regularly to ensure depreciation methods align with actual usage

Depreciation Strategies for Different Business Types

• Small businesses may benefit from using Section 179 to immediately expense qualifying assets and reduce taxable income
• Capital-intensive industries (manufacturing, construction) should optimize depreciation methods to match asset use and maximize tax benefits
• Technology companies can use accelerated depreciation for rapidly evolving equipment and software
• Real estate businesses should consider cost segregation studies to identify assets eligible for shorter depreciation periods
• Farms and agricultural businesses can use special depreciation rules for certain assets (e.g., single-purpose agricultural structures, certain livestock)
• Startups and growing businesses should plan depreciation strategies to align with long-term financial goals and cash flow needs
• Service-based businesses with fewer tangible assets may focus on depreciating intangible assets (e.g., software, patents)
• Businesses with irregular income or seasonal fluctuations can use depreciation to help smooth out taxable income over time