By Carissa Conley and Bryce Kahler
Every year, business owners across the country try to find ways to lower their taxable income and pay less taxes to the government. The easiest way to reduce tax is through operating expenses, which are necessary to run the business on a day-to-day basis. One of the most important expenses a business owner should take time to understand is depreciation: the expensing of business assets.
Depreciation requires you to spread the cost of an asset over its useful life as it loses value. The easiest method to understand is straight-line depreciation, where the cost of the asset is expensed evenly over its useful life.
If all assets were depreciated using the straight-line method, the business would have the same depreciation expense each year until the assets were fully depreciated. If the asset had a five-year life, it would take five years to get the full benefit of its cost.
But there are a lot of other depreciation methods and tax elections available to the business owner that create opportunities to manage their taxable profit in the year of purchase as well as in future years.
There are current tax laws that offer more favorable options to accelerate depreciation and immediately expense the cost of assets, thus lowering your taxable income for the year. It also enables you to match the expense with the cash outlay or, maybe even better, expense the property faster than you’re repaying the debt and thus put more money in your pocket now (which is why real estate investments are attractive).
Federal tax law lets you use Section 179 or what is known as Bonus Depreciation to expense certain assets immediately. Each option has its own rules, including which assets it can be applied to, and its own pros and cons.
An important note regarding Bonus Depreciation: Currently federal tax law provides for immediate expensing of 100 percent of the asset cost, but it wasn’t always 100 percent, and likely won’t be 100 percent indefinitely. Also, each state adopts is own accelerated depreciation rules and not all follow the federal tax treatment. Our state allows 179 expensing but not Bonus Depreciation, so this is an important consideration when determining which method to use.
There are a few potential disadvantages to recognize if you decide to use accelerated depreciation. If you sell a fixed asset before it is technically worthless based on your depreciation schedule, and your sales price is higher than the adjusted value, this gain will have to be reported as ordinary income instead of capital gain. Also, if your business is growing and you expect to have more profit in future years, the lower future deductions could result in more tax.
When making the decision whether or not to apply one of the methods of accelerated depreciation, be sure to consider its interaction with the current tax laws. A new business loss limitation has gone into effect which limits the amount of business loss you can use each year to offset other taxable income.
The NOL laws that were made favorable again during Covid and allowed business owners to utilize 100 percent of the NOL and carry it back to prior years to generate a tax refund, are no longer available. In addition, if you’re subject to the business interest limitations, reducing your taxable income as much as possible could result in losing deductions for interest expense. Thus, careful planning of capital expenditures and related depreciation deductions is more important now than ever.
Also, you cannot decide not to take depreciation. Many times we’ve gotten a new client with a rental property to find out that their prior accountant didn’t depreciate the property. Depreciation is a use-it-or-lose-it expense. You cannot choose to not depreciate a business asset so that you have a lower gain when you sell it.
If you don’t depreciate it from the beginning, when you sell the asset down the road, you still must calculate the gain as if you did take it. That means you never got the benefit of the deduction, but now you’re paying tax on a gain as if you did.
No two businesses are the same. Each year that you invest in capital assets, it is important to assess your individual situation and decide which depreciation method works best for you.