What is Depreciation?

There are a number of ways to depreciate assets. Here are some basics on what is depreciation and a look at some common methods.

What is Depreciation

The IRS allows tax filers to take a tax deduction for the wear and tear on property. Many types of property, both tangible and intangible, are depreciable.

Property must meet certain requirements for it to be depreciated. You need to own the property; property must be used in a business or to make money; and the property must have a useful life that’s greater than one year.

Depreciation on an asset starts when the business starts using it and continues to be depreciable until the cost has been recovered or the business stops using it, whichever comes first.

Section 179 Depreciation Deduction

In some cases, you can depreciate an item in year one, rather than spreading depreciation over several years. Some types of assets are better to depreciate in year one since they have a short useful life. This type of depreciation deduction is called a Section 179 deduction because that’s the part of the tax code that allows small businesses to take this type of deduction. In 2011, you can take a maximum of $500,000 Section 179 tax deduction.

There are several other ways to calculate your depreciation expense for each year. You might compare the depreciation amounts for each method to decide which one is best.

Straight-Line Depreciation Method

The straight-line method is the easiest way to calculate depreciation of an asset. You’ll need to know three things – the useful life of the asset, the salvage value of the asset (what it’s worth after its useful life has run out), and the cost of the asset. First subtract salvage value from the cost, and then divide by useful life. Using this method, depreciation will be the same each year.

For example, if the cost is $10,000, the salvage value is $1,000, and the useful life is 5 years, you would calculation depreciation like this: ($10,000 – $1,000) / 5 which equals $1,800.

Sum of Years Digits Method

Another way to depreciate an asset is to use the accelerated depreciation or sum of years digits method. The depreciation is taken as a percentage of the sum of all the years and most of the depreciation is taken upfront. For this depreciation method, you start by adding the sum of all the years. For example, if the asset life is 5 years, you would add 5+4+3+2+1 which equals 15. Take the highest percentage depreciation in the beginning:

Year 1 = 5/15 = 33.33%
Year 2 = 4/15 = 26.67%
Year 3 = 3/15 = 20.00%
Year 4 = 2/15 = 13.33%
Year 5 = 1/15 = 6.67%

Once you have the percentage for each year, calculate the depreciable amount of the asset, which is the cost minus the salvage value. Then multiple the depreciable amount by the percentage of depreciation to see how much you should depreciate the asset each year. For example, if the depreciable amount is $9,000, you would depreciate:

Year 1 = $3,000.00
Year 2 = $2,400.00
Year 3 = $1,800.00
Year 4 = $1,200.00
Year 5 = $600.00

Double Declining Balance Method

With the double declining balance method, the asset depreciates greatly in the first years, then at a regular pace later on.

The method starts by calculating depreciation using the straight-line method. Then, you calculate the percentage of the asset that’s depreciated in year one based on the straight-line method. Using our example above, the asset depreciates 20% in the first year. Then, you’d double that percentage to 40%.

In the first year, the appreciation would be $10,000 multiplied by 40%, to get $4,000. You have $6,000 left to depreciate.In year two, the depreciation would be $2,400. ($6,000 * 40%) and there would be $2,160 left to depreciate. In year three, the depreciation would be $2,160. In year four, the depreciation would be $864. In year five, depreciation would be $296.

Make a smart choice about the depreciation method you choose. Whichever method you choose in year one is the method you have to use for the remaining depreciable years.