Did you know that there are 31.7 million small business owners in the US alone? The goal of a healthy business is to grow its income & assets while minimizing taxes. But in order to calculate the accurate value of our tangible and intangible assets for taxes, we need to understand depreciation vs. amortization and how it can be used as a tax minimizing strategy.
Depreciation and amortization are two different methods to calculate tax write offs for tangible and intangible assets. Are you ready to learn more? Continue reading below!
What Is Depreciation?
Depreciation is an accounting method of calculating the value of assets and how much they decline over time. Certain assets have a life expectancy of over several years.
While the business needs to invest in these assets, through regular use and time, wear and tear are evident. This is when the asset depreciates; over time, it will add less value to the overall business, and in some cases, the asset might even become a liability.
There are several different depreciation expense methods to calculate the value of assets. We will take a look at the different methods.
Accelerated depreciation is a method of depreciation that takes into account the age of an asset. Assets have more value at the beginning of their lifespan and are therefore used more heavily. Accelerated depreciation takes this into account and adjusts accordingly.
But what does this mean, exactly? A great example is of a real-life situation is the purchase of a vehicle.
The initial cost of a vehicle is large, but a newer vehicle will also perform better than an older one. This is no news to you, of course. But we need to point out the obvious to understand how accelerated depreciation words.
The new vehicle will eventually lose value due to both age and use. In fact, a new vehicle will lose 15% of its value in the first year alone. Accelerated depreciation calculates how much the vehicle will decline in value each year.
Straight-line depreciation is one of the simplest methods of depreciation. Also called straight-line basis, it calculates the difference between the original cost of an asset and a resale value at a later rate.
This allows a business to stretch the cost over a longer period of time instead of all at once. We will chat more below on why that is important.
Straight-line basis and accumulated depreciation are similar in principle. However, accumulated depreciation differs because it calculates the decline of value until a certain point.
It is an important principle in GAAP, which stands for generally accepted accounting principles. A business will typically use this method to determine the total amount of depreciation each year and compare it with other years.
Finally, accumulated depreciation will match the balance sheet with its resale value, also called salvage value.
Other Depreciation Methods
The sum of the years’ digits is another popular form of depreciation. It is a happy medium between straight-line and accelerated depreciation.
This particular method is helpful in assets that decline in value fast or are more useful in the first few years.
Even accelerated depreciation can have different methods. For example, the accelerated depreciation method can include declining or double-declining methods.
Both of these methods are pretty aggressive in their depreciation. Both of these methods also work well if an asset is expected to decline quickly in the first few years, instead of a steady decline equally over the years.
How to Calculate Depreciation
Now on to the fun part; math! The formulas below will include the methods we discussed in the previous section.
To calculate depreciation, you will need to collect a few pieces of information. Start with the initial cost of the asset. Then, you will need to do some research to see the value of that particular equipment after years of use.
This will require some market research because each piece of equipment is different. Luckily, the IRS provides a list of the depreciable assets and even an idea of how many years that asset holds its value.
Calculating Accelerated and Straight-Line Depreciation
We will look at the two common methods of depreciation and their formulas. The first is a double-declining balance or DDB method.
- The depreciation formula for DDB is: (book value) – 2(sum of the years) = DDB
The second is straight-line depreciation or SLD.
- The depreciation formula for SLD is: (initial cost ÷ life)
Now, those are complicated terms and formulas. We will take a look at two examples below to gain some understanding of what these terms mean.
We will take one item and use both formulas to show the difference between the two methods.
Let’s say that your business purchases a company vehicle of $10,000. The usable lifespan of an average vehicle is five years.
First, we need to calculate the straight-line depreciation. Remember that we need to divide the original cost by the number of years the vehicle will be used.
- SLD: $10,000÷5=$2,000
$2,000 is the expected resale value. We then need to calculate how much percentage the vehicle depreciates each year.
With straight-line depreciation, we would deduct 16% or $1,600 off every year. However, we are using the DDB method, so we need to do some additional calculations.
We need to double the SLD.
So, for the first year, we are looking at a decrease in value of $3,200. In the second year, the vehicle will have a book value of:
- $10,000-32%=$6,800 (End of Year 1)
- $6,800-32%=$4,624 (End of Year 2)
- $4,624-32%=$3,144.32 (End of Year 3)
And so forth.
What Is Amortization?
There are two different circumstances where amortization is applicable. Amortization in the first circumstance references to the process of paying off loans. You’ll likely hear the term “amortization schedule” that refers to regular payment installments between you and the lender.
The second situation of amortization is for accounting and tax purposes, specifically when it comes to intangible assets. The process of amortization of assets means that you will spread out the expenses over a specific set of time.
We will cover the different assets below. However, by definition, intangible assets are an asset that is not physical but intellectual property.
Much like with depreciation, amortization has different methods as well.
Accelerated amortization is very different than accelerated depreciation. We know that the latter is a method used to calculate the depreciation of an asset for accounting purposes.
Accelerated amortization, on the other hand, is when the loan holder makes additional payments toward a loan. Instead of following the amortization schedule, the lender will accept more or larger payments.
Accelerated amortization would refer to the first situation we discussed above.
Straight-line amortization would refer to the second situation; charging the expense of an asset over a certain period of time.
However, it is also applicable to the repayment of loans. The amortization schedule on a straight-line basis is followed on a regular payment schedule with set amounts paid.
How to Calculate Amortization
Since there are two different methods of amortization used for either loans or assets, we will briefly look at both.
To calculate the amortization of the loan, you will need to collect some information. First, you will need to find the total monthly payment, the outstanding balance, and the interest rate.
Principal payment= (total monthly payment) – (outstanding balance x interest rate÷12 months)
To calculate the amortization of intangible assets, you simply need to take the costs of creating that asset and divide by the number of years you believe that asset will have value.
Let’s look at an example below.
For this example, we will say that we are looking to patent a product. Typically, a lawyer will charge anywhere between $8,000 and $10,000.
For simplicity’s sake, we will say that the total cost of a patent is $10,000 all-in. A company usually does not sell the patent, and when they do, the entire company gets absorbed into the sale.
Usually, patents last for 20 years, meaning they will maintain that value until then. The company does not wish to reinstate the patent at the time of expiration.
So, in this case, we will simply divide the costs by the number of years.
- Amortization of expenses: $10,000÷20 years=$500
At this point, you will claim $500 each year on your taxes.
At the same time, you will also need to calculate the amortization of your loans so that you can claim the correct amount of your interest as a deduction.
Let’s say that you took out a loan of $10,000 to cover the costs of the patent. You will repay the loan in 24 installments at 3% interest. However, you cannot simply claim the amount of the monthly payment as a deduction. Instead, you need to claim the amount of interest you paid in that year.
You pay 3% of the amount owing after each payment. In the first year, you will pay $232.65 in interest and $4,925.07 in principal. The following year, you will pay off the remainder of the principal and $82.84 in interest.
To calculate the monthly schedule of principal payments, take the balance, calculate the interest percentage, subtract that from your payment schedule, and you will see that you will consistently pay just over $400 in principle.
Depreciation vs. Amortization: What’s the Difference
The most significant difference between the two is the type of assets the method is applied to. Depreciation is an accounting method used for fixed assets, while amortization is used for intangible assets.
While we did speak of accelerated amortization, it is not necessarily applicable to taxes and accounting. But straight-line and accelerated depreciation are both common accounting methods.
What Is a Fixed Asset?
A fixed asset, also called a tangible asset, is an accounting term that refers to equipment or property owned by a business. An accountant would take a fixed asset and calculate the depreciation to adhere to the accepted principles of accounting, also called GAAP.
These assets provide the company with the necessary tools to operate the business. Each year, depending on the use and economy, an accountant will need to evaluate the price difference of each asset and add it to the balance sheet.
Current Assets vs. Noncurrent Assets
Fixed assets usually fall under noncurrent assets. The one item that current and fixed assets have in common is that they both show up on the books.
Current assets are items such as cash. However, they can also include easily liquified items, usually within a year. Current assets also include inventory, pre-paid expenses, and accounts receivable.
Fixed and noncurrent assets will have a longer life span and are not as quickly liquified, which means they are not easily turned into cash. Noncurrent assets include items such as real estate, investments, or intellectual property.
What Is an Intangible Asset?
The most important thing you need to understand about intangible assets is that it is not a physical asset, which means that it is not a piece of equipment or property.
This can mean either a legal agreement, a brand name, patent, or more. However, they are usually classified as either indefinite or definite.
Indefinite vs. Definite Asset
An indefinite asset is something that will last for the entire lifespan of the business—for example, a brand name, trademarks, and goodwill.
On the other hand, a definite asset can be a contract, legal agreement, or patent. They are assets that do not have any physical attributes but are set to expire at a certain point in time.
How to Value Intangible Assets
It is no secret that fixed assets are a lot easier to evaluate than intangible assets. One can compare their equipment to determine the state and the remaining use of the physical asset.
However, one could argue that intangible assets are subject to different circumstances. Intangible assets are expensed like any other asset, but the value of these is not recorded in the books.
When these assets need a valuation, an expert and accounting will determine how well the company would perform with or without the asset.
Depreciation vs. Amortization: Filing Your Taxes
So what does all this have to do with taxes? And how do you report your expenses to the IRS?
The IRS allows companies to file the expenses of assets to lower taces. For example, the deductions from the depreciation expenses of a vehicle will lower your overall income. Even if the asset is already paid for, you can still claim the expenses as the asset is not worth as much through use and time.
Deductions lower your annual income, both individual and business taxes, while credits reduce your overall tax bill. This means that you may fall into a lower tax bracket, and as a result, you may owe a smaller percentage of your income to the government.
A business would file the deductions from both depreciation and amortization expenses on Form 4562.
How to File a Form 4562
A form 4562 is specifically designed for these types of expenses. However, the depreciation and amortization of each asset require a separate form.
For example, you must file a form for each piece of equipment, vehicle, and property. Additionally, you will need to submit a form for each intangible asset as well.
You need to include your name or the business name, the ID number, and the particular asset being filed.
Keep copies of each year that you file the depreciation of an asset as you may need to reference them in later years.
Listed property is used interchangeably between an individual’s personal life and business life. For example, say that you have an in-home office with a well-running computer that you also use to connect with family and friends. You would file these types of assets under the “lister property” section.
Otherwise, you need to apply the methods we discussed to report the depreciation of an asset and claim how much the depreciation expense cost that year.
Alternatively, you can file an asset under section 179. A one time deduction that takes the salvage value and depreciation into account.
What is Section 179?
Section 179 refers to the initial costs of a depreciable asset. Instead of claiming the depreciation over the year, a business owner can claim the entire amount at first.
This method is usually helpful when the business owner does not expect to salvage the equipment, meaning that they will use it until it no longer has any value on the market.
For example, suppose your company buys an asset for $10,000, and it is expected to depreciate over five years in both accelerated and straight-line depreciation. In that case, you will only claim the depreciated expense every year.
However, section 179 allows a business owner to claim the full expense right at the beginning, giving a significant tax break that specific year. This is especially useful in situations of new companies.
Accounting vs. Tax Depreciation
During your research, or perhaps during a conversation with your accountant, you may have come across the terms of accounting depreciation and tax depreciation.
Accounting depreciation is the method that falls under the GAAP principles, meaning that this method is required to balance out the books. Accounting depreciation is not a method to calculate the current assets of a company, such as cash flow, inventory, etc.
However, since tangible assets are part of proper bookkeeping practices, the books do need to include a record of the depreciation of tangible or fixed assets.
You need to include the end of the year, the book value, the yearly depreciation expense, and the tally of the total depreciation.
For example, taking our earlier example when we purchased a vehicle together:
- End of year 1:
- $10,000 (Book Value)
- $3,200 (Depreciation Expense)
- $3,200 (Total Depreciation)
- End of year 2:
- $6,800 (Book Value)
- $2,176 (Depreciation Expense)
- $5,376 (Total Depreciation)
And so forth. This example is based on accelerated depreciation instead of straight-line depreciation.
Tax depreciation is the process of filing these depreciation expenses to the IRS. You will include the book value, the depreciation of this year, and reference the depreciation of last year’s taxes as well.
What is MACR?
MACR stands for modified accelerated cost recovery. It includes two different systems, the general depreciation system or GDS and the alternative depreciation system or ADS.
The GDS would apply to the methods we have discussed in detail above. In addition, it usually applies to vehicles, computers, and other assets that do not have a long lifespan.
However, assets such as buildings would fit better with the ADS method. It allows businesses to apply a depreciation schedule for a longer period. However, once a business applies this method, they need to apply it to all properties in the same category, and it cannot be changed.
For example, if you purchase your first warehouse in 2018 and decide to use the ADS method, you must apply it again when you expand and purchase an office building.
Unit of Production vs. MACR
While the IRS requires your company to report the depreciation of your assets with the MACR system, you can use a different method for your own books.
The unit of production method allows you to depreciate your asset by use instead of time. So, instead of a yearly decline, you can set the depreciation measured by how often a piece of equipment is used.
For example, let’s say you own a small business where your clients ask for deliveries on a regular basis. However, during COVID, deliveries increased, and your delivery fleet saw much more use than in other years. You could claim that your vehicles saw a significant decrease in value due to extra mileage and other uses.
When using this method, you can exclude certain claims in the tax years when the equipment saw less use.
Depreciation vs. Amortization: Know the Difference
When filing your taxes, you have to know the difference between depreciation vs. amortization. One is applicable to fixed assets, such as equipment, property, and vehicles, while amortization is a method useful for intangible assets.
Accounting and filing taxes is complicated, but you are not alone. Keep browsing our business section to learn about the proper accounting practices you should apply to your small business.
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