Wear and tear, age, deterioration and obsolescence are a few of the reasons why property depreciates in value. By taking a deduction for depreciation on your tax return, you can recover the cost of certain property or equipment you use in your business or for the production of income.
If you buy a piece of equipment, depreciation of its original cost should be included as an expense on your monthly operating statement. If you lease a piece of equipment, the monthly lease payment is part of your monthly operating expenses (cash-value depreciation is frequently figured into the cost of an equipment lease and need not be figured separately by you).
Many equipment-leasing agreements have a clause providing for what's known as a "depreciation reserve." This consists of setting aside money commensurate with the declining value of the vehicle. When the lease is up, the equipment is sold to either the lessee or another third party. If it goes for a price over and above its depreciated value, the difference can be refunded to the lessee. If, however, the equipment is sold for a price under its depreciated value, the lessee must pay the difference to the lessor. This is where the depreciation reserve comes in handy.
Straight-line or uniform depreciation is the most frequently used method of depreciating new equipment for financial statements. In straight-line depreciation, the equipment loses an equal part of its total value every year of its life. For your tax return, though, your accountant will most often use a tax-approved depreciation that gives you the largest deduction on your tax return and goes farther in minimizing your taxes.
Suppose you buy a $15,000 printing press with a ten-year useful life, according to your accountant's schedule. The straight-line depreciation rate is calculated by dividing its ten years of useful life into the $15,000, or $1,500 a year. If you're in the 28 percent tax bracket, $1,500 in depreciation will save you $420 in taxes. Suppose you only need 20 percent down to buy a $15,000 machine. Suppose, too, that you financed your press on the installment plan. The interest you pay on any amount owed is going to be another deduction for you. So if you have a $12,000 loan that costs $1,200 in interest, you'll wind up with another $336 (in the 28 percent bracket) in savings.
The current methods of depreciation are often referred to as MACRS (modified accelerated cost recovery system), whereas the method used for any assets acquired before December 31, 1986 is often called ACRS (accelerated cost recovery system). Assets used in your trade or business that were purchased before that time are depreciated using different methods than those discussed here. Those earlier methods generally provided a larger depreciation deduction than the current rates.
Keep in mind that many states have different sets of rules than those used on your federal income tax return for allowable depreciation methods on state tax returns. You should check with your tax professional to find out more about the rules in your state.