When you hear the word “depreciation” you may think that it’s not a nice word since it sounds contrary to “appreciate” but it’s actually not! It may sound weird because depreciation appreciates all the tax savings it will give you. Depreciation is the method of reducing the total cost of something expensive you’ve purchased for your business. However, rather than writing it all in one tax year, you do parts of it over time.
If you want to know how depreciation can benefit you and your business and if you want to understand how to calculate depreciation rates, then this article is for you.
Understanding the Basics of Depreciation
When you are depreciating assets, you can arrange how much money is written off every year, providing you with more control over your finances. The total of years over which you depreciate an asset is determined by its “useful life” (for example, a laptop has a useful life for about five years). When it comes to tax depreciation, various assets are sorted into different classes and every class has its own useful life. If you own a business and you’re using a different method of depreciation for your financial statements, you may decide on the asset’s useful life based on how long you will efficiently use the asset in your business.
For instance, the IRS can require that a piece of computer equipment get depreciated for five years, however, if you know that it will be futile in three years, you may depreciate the equipment over a shorter time.
What is an Asset?
Anything can be an asset as long as it has a dollar value. The IRS recognizes assets as “property”, and they can be tangible or intangible. Office buildings, computers, delivery trucks are examples of tangible assets since they can be touched. Meanwhile, copyright, patents, or other intellectual property is considered intangible as you can’t touch them but they can be sold or purchased.
This means that intangible and tangible assets can be depreciated. It’s also important to take note that when it comes to intangible assets, the act of depreciation is known as amortization.
What Kind of Assets Can You Depreciate?
The IRS is the one responsible for setting the guidelines on what kind of assets you may depreciate. These assets need to meet the following criteria:
- You are the owner of the asset
- Assets are utilized in your business or used to produce income
- Its useful life is determinable
- You expect the asset to last more than one year
Here are some of the common examples of assets that can be depreciated by small businesses such as:
- Real estate
- Office furniture
What is a Depreciation Rate?
This is the percentage rate at which an asset is depreciated over the estimated useful life of the asset. It can also be defined as the percentage of a stable investment done in an asset by a business which business claims as a tax-deductible cost over the productive life of the asset. It is distinct for every class of assets.
How to Calculate Depreciation Rates?
When it comes to calculating depreciation rates, there are various formulas you can use. The straight-line method is the most widely used formula among all. Here’s how it works:
Depreciation Rate every year: 1/useful life of an asset
Depreciation Value every year: Price of an asset – Salvage value of an asset/ Depreciation rate every year
Take note of the terms below before calculating:
Cost of asset: This is the initial book value of the asset. The taxes paid or shipping charges paid for the asset are the ones included.
The productive or useful life of the asset: This is the time span for which an asset can be used or operated properly. After the useful life, the asset is considered to be cost-ineffective or inefficient for operation or consumption. A respective revenue authority will be the one to define the useful life of some assets such as real estate, computers, and etc. For example, vehicles are usually depreciated across 8 years, while computers are depreciated over 5 years.
Salvage value: Worth of an asset after the useful life of the property at which a business can sell the asset. This is also referred to as the scrap value.
Advantages of Depreciation Rates
It helps to expand the cost of an investment in fixed assets across the productive life of the asset. In this way, the business does not need to account for the cost in the first year, otherwise, the company will have to sacrifice losses in the year of purchase.
It gives companies the proper market value of assets so that reflecting the wear and tear the asset may have had grounds of years it has been utilized for.
It helps companies generate tax savings for their business.