Depreciation of Business Assets

An asset is property, such as a computer, copying machine, car, truck, or other equipment you acquire to help produce income for your business.

Because assets wear out, you are allowed to write off (or "depreciate") part of the cost of your assets over a period of time. You can start depreciating the year that the asset is ready to use in your business.

For tax purposes, there are six categories of non-real estate assets. Each has a designated number of years that assets in that category can be depreciated. Here are the most common:

• Three-year property (tractors, certain manufacturing tools, some livestock, etc.)
• Five-year property (computers, office equipment, cars, light trucks, assets used in construction, etc.)
• Seven-year property (office furniture, appliances, property that hasn't been placed in another category, etc.)

You are allowed to write off real estate property over a longer period:

• 27.5 year (residential rental property)
• 39 year (commercial property, buildings, factories)

Land is not depreciable (it doesn't wear out), but land improvements, such as roads, sidewalks or landscaping may be written off over periods of 10, 15, or 20 years depending on the specific nature of the asset.

Note: When you use TurboTax Business and TurboTax Home & Business software to prepare your business return, we do the math for you. All you do is answer a few simple questions about each asset.

Types of Depreciation

There are three primary methods you can use to depreciate your business assets (and variations of each of these methods):

1. Straight line depreciation is the simplest. You deduct the cost of the asset in equal amounts over a set period of time (except in the first and last year, when you take half* the amount you would normally deduct).

*This is called the "half-year convention," which means that half the deduction amount is allowed in the first year, regardless of what month you started using the asset for business. (If you acquired more than 40% of your assets in the last three months of the year, you would use the "mid-quarter convention," meaning that all the assets acquired in each quarter would be depreciated starting at the mid-point of that quarter.)

For example:

You buy a copying machine for $1,600 in the month of March. A copying machine is considered 5-year property for tax purposes. Using the straight-line method, you can take the following deductions in the first three years:

*The 50% calculation represents the "half-year convention" described above.

2. Accelerated depreciation — This method is the most commonly used by small businesses. It lets you take a larger deduction in the first few years and a smaller write off later. In the tax world, the most common accelerated method is called MACRS (Modified Accelerated Cost Recovery System). It starts with applying 200% or 150% to the cost and switches to straight-line depreciation at the most opportune time.

For example:

Your business bought $2,000 worth of office furniture and started using it May 1. Office furniture falls into the 7-year category. The first three years of MACRS depreciation deductions would be:

*The 50% calculation represents the "half-year convention" described above.

TurboTax Tip: It may not be prudent to take the biggest deductions in the first years that you are in business. Assuming that you will earn more income as the business grows, you may want to use the straight-line method, which will give you the best long-term tax benefit.

Note: If you choose the straight-line method to depreciate an asset, you cannot switch to MACRS later. However, you may use a different method for assets acquired in each subsequent year.

3. First-Year Asset Expensing (Section 179 Deduction) — It's a dry name for a deduction (taken from a line in the IRS tax code) but it allows you to deduct the entire cost (subject to certain limitations) of an asset in the year you acquire and start using it for business.

Here are the rules and limitations:

• The asset must be tangible personal property (not real estate).
• It must be used in a trade or business (property used in a rental activity is generally not eligible).
• You must take the deduction in the year you start using the asset.
• The decision to use Section 179 must be made in the year the asset is ready to use for business.
• The deduction cannot be more than your earned income (net business income and wages) for the year.

For 2007, the maximum Section 179 deduction is $125,000. If your total acquisitions are greater than $500,000, the allowable deduction is phased out.

If the business is an S corporation, partnership, or multi-member LLC, it cannot pass the 179 deduction on to shareholders, partners, or members unless the business has income. The individual must also have earned income to take the deduction in 2007.

The Section 179 deduction cannot be taken on investment or retirement income.

Note: TurboTax walks you through the Section 179 deduction for applicable assets and handles the calculations, too.

TurboTax Tips:

• There is no advantage to using Section 179 for business autos. They are subject to a luxury auto limit for depreciation, which applies whether the deduction is claimed using depreciation or Section 179.
• Any Section 179 deduction that is not used in the current year because it is greater than your business income can be carried over to subsequent years.
• If a business (S corporation, partnership, LLC) has no operating income but the shareholder, partner, or member has taxable income, it would be better for the business to use regular depreciation. Regular depreciation becomes part of the business operating loss that passes through to the shareholder, partner or member.

A Comparison

Why use Regular Depreciation?

You may earn more from your business in the future, and it's possible you will save more in the long run by spreading out the expense over a few years.

For example:

You bought a computer for $2,000, and you use it entirely for business. We'll also assume you think that your business will grow beginning next year. The resulting higher profits would move you into a higher tax bracket, so you might pay 25% on additional income next year compared to 15% now.

If you take the Section 179 expense for the entire cost this year:
You'll deduct $2,000 this year, and save $2,000 X 15% = $300 on your taxes this year.

If you depreciate the computer over several years: You'll deduct $400 this year and the remaining $1,600 over the following five years, saving $400 X 15% = $60 this year, and $1,600 X 25% = $400 over the next five years. That's a total of $460. (Keep in mind, if you also pay taxes to your state, you may save even more in the long run.)

Why Use the Section 179 Deduction?

If your business is showing a profit, taking the Section 179 deduction will reduce your profit this year, which means that you'll pay less tax and keep more of what you earned.

Note: If you take the Section 179 deduction on an asset, you're required to continue using the asset more than 50% of the time for business. If business use of the item drops to 50% or less during the years you're depreciating the item, the IRS will retroactively deny your Section 179 deduction. You will have to declare the deductions already taken as taxable income.

The Bottom Line:

Section 179 can save you tax dollars, but remember:

• You must have earned income.
• The entity (Partnership, LLC, S Corporation) must have business income in order to pass the deduction through to partners, members or shareholders.
• There are times where regular depreciation results in a larger deduction, so planning is required.