Tax Depreciation: The Impact of Depreciation on Taxes

tax depreciation

Tax depreciation is the cost of depreciation of a corporation and is an IRS deduction. This means that a company may minimize its taxable income by listing depreciation as an expense on its income tax return for income tax purposes in the reporting period.

Depreciation is a process in which fixed assets or capital assets pay in the years in which assets contribute to the generation of income or sales or when they are of benefit. The business decreases the income from which taxes are focused by generating a depreciation expense, which lowers the taxes owed. By filing Form 4562 for their tax return, companies will take a depreciation deduction.

What this article covers:

What Does Tax Depreciation Mean?

Tax depreciation is a mechanism in which taxpayers cancel the depreciation on their tax returns as a cost, which helps companies recover their expenses with a particular asset form. 

Depreciation is the steady decline over the lifetime of the fixed asset. This is the amount you have to subtract to recover the asset expense. It is only possible for you to depreciate real assets (other than land) held by your corporation as a determinable useful life and intended to continue for over one year for sales production operations. Until those laws are fulfilled, the asset’s full cost shall be paid for the time of incurrence.

Unlike a book or accounting depreciation focused on the concept of matching the records and reporting on an organization’s financial statements, the company’s income tax returns document tax depreciation based on the IRS laws and the rules.

Which Depreciation Method Is Used for Tax Purposes?

While the calculation is carried out using the straight-line approach that results in an equivalent spread of the cost over the asset, the tax depreciation calculation is carried out using the Modified Accelerated Cost Recovery System (MACRS).

MACRS:

In the first five years, companies can depreciate their assets quicker than they did in previous years, according to the depreciation process Modified Accelerated Cost Recovery System (MACRS). 

While this solution will decrease revenue tax in the first years of the asset’s existence, it may not have the depreciation tax advantages in the later years.

Section 179 Deduction:

An organization may opt to use the exemption on other property in compliance with section 179. You may deduct a limit of $1,000,000 in 2018, as per section179 Deduction in the year you acquire the asset. The full deduction continues to be phased out if your gross acquisitions are over $2,500 000. The deductions that the company may not need will be passed to the subsequent years in the current year. 

Because of discrepancies in calculation techniques, businesses typically hold different reports on the depreciation of books and taxation.

What Is a Tax Depreciation Schedule?

You will optimize the cash return on your company or investment property each financial year by establishing a tax depreciation plan. Any missing deductions from the previous year can also be claimed in this schedule.

How Does Depreciation Work on Taxes?

Depreciation is a tax deduction that helps you to recover the cost of the products you purchase and use. 

In relation to the depreciation of the financial statements closely aligned to the actual usage of the assets, the tax depreciation rate is measured on the basis of the asset classification, independent of the real use. 

You have to complete Form 4562 for the purposes of requesting a tax deduction on each asset after you have determined depreciation. Your tax return should include this form. Whenever you are not aware of the level of the depreciation and how to disclose it correctly, a tax attorney should be consulted.

Methods of Calculating Depreciation:

Each method recognizes depreciation expense differently, which changes the amount in which the depreciation expense reduces a company’s taxable earnings, and therefore its taxes.

Straight Line Basis

Straight-line basis, or straight-line depreciation, depreciates a fixed asset over its expected life. In order to use the straight-line method, taxpayers must know the cost of the asset being depreciated, its expected useful life, and its salvage value; the price an asset is expected to sell for at the end of its useful life.

For example, suppose company A buys a production machine for $50,000, the expected useful life is five years, and the salvage value is $5,000. The depreciation expense for the production machine is $9,000, or ($50,000 – $5,000) ÷ 5, per year.

Declining Balance

The declining balance method applies a higher depreciation rate in the earlier years of the useful life of an asset. It requires that taxpayers know the cost of the asset, its expected useful life, its salvage value, and the rate of depreciation.

For example, suppose company B buys a fixed asset that has a useful life of three years; the cost of the fixed asset is $5,000; the rate of depreciation is 50%, and the salvage value is $1,000.

To find the depreciation value for the first year, use this formula: (net book value – salvage value) x (depreciation rate). The depreciation for year one is $2,000 ([$5000 – $1000] x 0.5). 

In year two, the depreciation is $1,000 ([$5000 – $2000 – $1000] x 0.5).

In the final year, the depreciation for the last year of the useful life is calculated with this formula: (net book value at the start of year three) – (estimated salvage value). In this case, the depreciation expense is $1,000 in the final year.

Sum-of-the-Years’ Digits

The sum-of-the-years’ digits is an accelerated depreciation method where a percentage is found using the sum of the years of an asset’s useful life.

For example, company B buys a production machine for $10,000 with a useful life of five years and a salvage value of $1,000. To calculate the depreciation value per year, first, calculate the sum of the years’ digits. In this case, it is 15 years, or (1 + 2 + 3 + 4 + 5). The depreciable amount is $9,000 ($10,000 – $1,000).

In the first year, the multiplier is 5 ÷ 15, since there are five years left in the useful life; in the second year, the multiplier is 4 ÷ 15; in the third year, the multiplier is 3 ÷ 15; and so on. The depreciation value is $3,000 ([$10,000 – $1,000] x [(5 ÷ 15]). Use this method up until the salvage value.

Difference Between Book and Tax Depreciation

Generally, the difference between book depreciation and tax depreciation involves the “timing” of when the cost of an asset will appear as depreciation expense on a company’s financial statements versus the depreciation expense on the company’s income tax return. Hence, the depreciation expense in each year will likely be different, but the total of all of the years’ depreciation expense for an asset will likely add up to the same total.

The difference between book and tax depreciation leads some people to say, “Oh, the company has two sets of books.” The fact is the company must 1) maintain depreciation records for the financial statement depreciation that is based on the matching principle, and also 2) maintain depreciation records for the tax return depreciation that is based on the IRS rules.

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