Small business owner? Learn to calculate depreciation on your own!
For small to medium entrepreneurs, it is quite crucial to consider all possible(legitimate) ways to save money on business taxes and take every individual business deduction they are authorized to. However, SMB owners often obliterate depreciation, also known as amortization, which enables one to calculate the decline in the value of the business property to offset the income from the trade. As the fixed assets eventually lose value over time because of their age, decay or wear and tear, small businesses should ideally find a way to benefit during asset depreciation. A noteworthy income tax deduction can be observed when assets depreciate. It is generally considered as the government’s way to support small businesses as it makes building and equipment purchases affordable for the businesses that are not financially strong.
Fundamentally, the depreciation value is turned into an annual income tax deduction. For businesses depending on expensive equipment, the deduction can be quite significant to reduce their taxable income. However, as depreciation is considered a non-cash expense, it can never impact the cash flow of a business or the original cash balance.
Types of depreciable assets:
Besides physical items like a piece of equipment or properties, patents and software, which can be defined or stored in a computer, respectively, can be considered as assets. In short, the assets should be tangible.
Only purchased property can be considered as assets. Properties that are used at least one year are qualified for the depreciation deduction.
Assets, chiefly used for personal use but occasionally used for business purposes cannot qualify.
An entrepreneur cannot show any assets purchased from close family members like siblings, spouses, parents, grandparents, grandchildren or children, to get a deduction. Also, assets bought from companies, trusts and charitable organizations, the entrepreneur has a relationship with, are not eligible.
Among physical assets, come buildings, computers, equipment, machinery, office furniture and work vehicles.
Depreciation calculating methods:
One can start depreciating a property once it is in use and put a halt when the acquired depreciation has entirely recovered its cost.
Following this method, a trader can depreciate a business property a fixed amount every year throughout the period it is used. One just needs to subtract the salvage value (the amount that can be gained by eventually selling it) of the asset from its cost, to get an idea about the amount that can be depreciated each year. Finally, the amount needs to be divided by the useful life of the asset, in years. For example, if someone has bought a pizza oven at $800 and it has a four-year useful life, post which he/she has a plan of selling it, the expected selling price is $200.
Step by step process:
The total cost of the asset(cost of the asset + shipping charges + taxes) needs to be calculated. While calculating the cost of an asset to depreciate, all related costs like material costs, labor, taxes etc. need to be added as well.
The salvage value needs to be subtracted from the asset’s cost. Salvage Value is the price one expects to sell an asset at, after the useful life is over.
The asset’s useful life needs to be calculated.
The annual rate of depreciation needs to be decided on. This can be done by using a formula; 1/years of useful life of the asset.
The depreciation rate needs to be multiplied by the asset’s depreciable cost. Formula to calculate the annual depreciation expense of an asset is; depreciation rate x (total cost of the asset – salvage value).
Lastly, the monthly depreciation expense can be calculated by dividing the annual depreciation expense by 12.
This method enables one to calculate depreciation by taking larger depreciation deductions in the initial years of the asset’s useful life and smaller ones in the final or later years. Often, this is followed by small to medium businesses.