A lot of times when we ask new clients if they know what depreciation is they respond, "Yes it is when your car loses value." While this is one type of depreciation, it is not what depreciation means from a tax stand point. Depreciation in relation to taxes is when a company buys an asset, like a computer, vehicle, building, or equipment, and instead of taking the entire expenditure in the year of purchase, the asset expense is taken over several years.
For example, if you purchased a computer for two thousand dollars, you do not deduct the $ 2,000 right away. You would take a portion of that deduction every year for five years. Thus, the computer is depreciated over five years.
Depreciation is helpful because most businesses have less income and more expenses the first couple of years. Since a business buys the bulk of its equipment at the start of the business, depreciation allows you to extend the discounts to years when the business has more income and needs to take more discounts.
The type of asset you are purchasing determines how many years it is depreciated. The typical years are 3, 5, 7, 15, 27.5 or 39 years. In addition, there is extra depreciation that you may be able to take the first year you purchase an asset. This is the section 179 depreciation. For example, some types of vehicles can be depreciated almost entirely in the first year, and depending on your net income, other equipment can be deducted a hundred percent in the first year. With these types of flexibilities you can strategize when and how much to depreciate to give you the best tax savings possible from year to year.
For example, if you own an established business and are making a large profit and you buy new equipment it may be beneficial to deduct 100% of the equipment that year because it would offset your income. Another example is if you have a large windfall that is not normal every year so you want to take additional depreciation the year you buy some equipment to help offset your gain. Other new business or even established business that do not have a lot of income have the flexibility to take the expense of the equipment over the appropriate amount of years to spread out the expense and benefit from the expense in years when they have higher profits.
Depreciating your assets can be a little tricky. There are many rules and many ways to strategize using those rules. It is important to educate yourself on tax topics like depreciation and consult with a tax professional to make sure you are doing things correctly.