Commonsense CPA: Demystifying Depreciation

"A rose by any other name would smell as sweet"  - William Shakespeare

I look forward to Fall every year. The return of school, football, cook-out weather, and PSLs help ease the transition into another tax season. Maybe that acronym raised a smile, or elicited a pained groan, or maybe you have no idea what I’m talking about.

I’m an unashamed lover of Pumpkin Spice Lattes. PSLs for those in the know. Ask me how many I’ve already had this month.

We place a premium on what language communicates, but sometimes what it doesn’t communicate is just as important. Language can serve a gatekeeping function, especially true in the professional world. Our restaurant clients will immediately know what “Fly 42, 86 ravioli, ten steak all day” means but most of us would be puzzled. 

One of our jobs at Harmony is to help you interpret accounting language - to cut through the inscrutable tax code, byzantine concepts, and impenetrable jargon and present things in a way that you can use to make sound financial decisions. Parsing those signals isn’t easy, especially in unprecedented times like today’s economic climate. Unemployment is down, inflation is up, growth is down, the dollar is strong – does this mean we’re in a recession?

For this month’s Commonsense CPA we’re decoding depreciation, something that’s devilishly complex but critical for people to understand. After cutting through the jargon, the basic concepts are easy to grasp, and we hope that you’ll be able to make better decisions around how to treat this powerful deduction.

We’re always here to help interpret the complexities of your financial picture – some of us fueled by a delightful little taste of Autumn.

Matt Hetrick, CPA
President and founder of Harmony Group Inc.

Demystifying Depreciation

Accounting, like most professions, has its own jargon that can make simple concepts completely inscrutable because jargon filled anti-language can befuddle people who don’t speak it. At the Commonsense CPA, we strive to decode the secret language of accountants.    

A concept worth decoding is Depreciation, one of the most important and hard to understand concepts in taxation. 

The dictionary defines depreciation as: (1) decrease in value due to wear and tear, decay, decline in price, etc. (2) such a decrease as allowed in computing the value of property for tax purposes.    

These two definitions work in harmony in the tax code – the government recognizes that the longer you use an item the less value it has due to wear and tear. The government wants to encourage investment in business assets, so the tax code has deductions to allow you to recoup some of the cost of the asset via deductions.   

What is a deduction? A deduction or deductible is money spent by a taxpayer that the IRS allows the taxpayer to claim on their tax return reducing the amount of income that is taxable, equivalent to the tax treatment of an expense of the business. Significant recurring deductions like depreciation (for tangible assets) and amortization (for intangible assets) often appear on a P&L statement as expenses, reducing profits that a company is responsible to pay taxes on.

How does property qualify for a depreciation deduction? To be depreciable property must meet all the following requirements: (1) it must be property you own; (2) it must be used in business or income-producing activity; (3) it must have a determinable useful life; and (4) it must be expected to last more than 1 year.  Also, you also cannot deduct more than you paid for the asset you plan to depreciate.

For items that are for business and personal use, it is necessary to allocate the use among its various purposes. For example, to claim depreciation on an automobile that is used for both business and personal driving, you take the mileage used for business purposes and divide that usage by the total usage to figure out how much of the cost of the asset is depreciable.

The determinable useful life means that the asset is something that will wear out from use in a certain period. Land and financial instruments don’t depreciate because they don’t degrade or wear out.  Figuring out the timeline to depreciate an asset is complex.  Items are depreciated according to their recovery period in the Modified Accelerated Cost Recovery System (MACRS).  Different asset classes depreciate at different rates ranging from 3 years to almost 40 years.  Your tax team at Harmony will help you determine the appropriate distribution schedule for your assets.

The first step to making a depreciation deduction is determining what you paid for the asset (your initial “basis”), when you started using the asset (when it’s put in service), and the appropriate recovery period of the asset you want to depreciate.  Once you’ve determined this information you can decide the size of the depreciation deduction by electing to use one of two methods allowed by the IRS: straight line depreciation or the declining balance method.

Straight-line depreciation is the most straightforward for determining a depreciation deduction, you simply claim the same size depreciation deduction every year of the allowed recovery period. The declining balance method allows you to recover more money in the initial years of the recovery period by creating an adjusted basis by increasing the earlier deductions. You use the same timeline but raise the deductions you take in the initial years by 150% or 200% of the result of the straight-line method. 

A brief example of the difference using a 5-year recovery period and 200% declining balance deduction:

This table shows the increased deductions of the declining balance method in the earlier years and illustrates an important point – that if you’re using the declining balance method you must switch over the straight-line depreciation method the first year that using the straight-line method would give you a greater or equal deduction.

Now if five years is too long for you to wait, the IRS does allow you to take the entire depreciation deduction in a single year.  There are two ways to do this – the Section 179 Deduction and Bonus Depreciation. 

The Section 179 deduction allows you to take a depreciation deduction up to your basis in the property’s initial year of service with certain limitations such as Section 179 cannot create a loss.  Although it is indexed to inflation, the total deduction limit is around $1M and is reduced by the value of Section 179 property put into service that exceeds $2.6M. There are also specific limitations around how much you can deduct various types of property.

Bonus Depreciation allows you deduct the full depreciable amount in the first year without regard to loss limitations.  The bonus depreciation percentage allowed by the IRS drops to 80% next year before gradually phasing out. 

Have you seen the Tik Toks or Instagram videos saying you can get a Mercedes G-Wagon (MSRP $131,750) much cheaper if you use it for your business more than 50% of the time? It’s a perfect encapsulation of the complexities of depreciation deductions.  A maximum Section 179 depreciation deduction for SUVs with a gross vehicle weight (GVW rating) of more than 6,000 lbs is $26,200.  However, under bonus depreciation rules you can deduct 100% of the cost of a vehicle with a GVW rating over 6,000 pounds, even if it creates a tax loss. Depreciation rules are crammed with various benefits to taxpayers such as the ability to take a full Section 179 for some pick-up trucks, race-horses, fruit and nut trees to name a few items. 

It's not necessarily advisable to take Section 179 or Bonus Deprecation deductions as the calculus depends on your profitability, entity structure and tax strategy.  How and when to depreciate business expenses should be a vital part of your small business tax strategy.

Hopefully now you understand the language of depreciation and are prepared to have a conversation with your Harmony Tax Advisor about the best asset purchase and depreciation strategies for your small business.

Journal Entries

The ____ is too Damn High (Part II):

The average rate on a 30-year fixed mortgage rose to 5.89%, the highest rate since 2008. Remember what was going on in the housing market in 2008? Mortgage rates, almost double from a year ago, will likely keep going up as the Federal Reserve remains committed to lifting rates to try and tame runaway inflation. While most people focus on the sticker prices of houses, it is the ability to afford the monthly mortgage payment that is critical for homeowners’ ability to afford housing, so these rates have cooled housing demand considerably.
 

Federal Student Loan Forgiveness is Here (Sort of.):

President Biden signed an executive order to cancel $10,000 of federal student loan debt for single taxpayers who earn under $125,000 ($250,000 for married taxpayers).  If you meet these requirements and have a Pell Grant, you could be eligible for an additional $10,000 of loan forgiveness. Eligibility will be based on 2020 and 2021 income and applies to most federal student loans. Forgiveness of any debt usually incurs a tax burden but §9675 of the American Rescue Plan changed the code to eliminate the tax burden for forgiveness of student loans through 2025. The exact process is still being determined and we will keep you updated as we learn more.