Capital Assets and Depreciation

Almost every business must invest in some major equipment, vehicles, machinery, fixtures or furniture in order to operate. Some businesses will require assets such as land, a building, patents, or franchise rights. Major assets that will be used in your business for more than a year are known as "capital assets" and are subject to special treatment under the tax laws. Most importantly, you generally can't deduct the entire cost of acquiring such an asset in the year you acquire it.

Why not? Because one of the goals of accounting is to accurately measure a business's gross income, expenses, and net income (earnings) during a given period of time, usually a year. If a business were allowed to reduce one year's gross income by an expense deduction for the total cost of an item that will be used for several years, the result would be an understatement of earnings in the year the asset was purchased, and an overstatement of earnings during the following years.

It follows that, for "capital assets" (assets that have a useful life of more than one year), the cost must be written off (that is, depreciated or amortized) over more than one year.

Theoretically, the cost of an asset should be deducted over the number of years that the asset will be used, according to the actual drop in value that the asset will suffer each year. At the end of each year, you could subtract all depreciation claimed to date from the cost of the asset, to arrive at the asset's "book value," which would be equal to its market value. At the end of the asset's useful life for the business, any undepreciated portion would represent the salvage value for which the asset could be sold or scrapped.

Since the actual drop in value of each business asset would be difficult and time-consuming to compute (if indeed it could be computed at all), accountants use a variety of conventions to approximate and standardize the depreciation process.

For example, the straight-line method assumes that the asset depreciates by an equal percentage of its original value for each year that it's used. In contrast, the declining balance method assumes that the asset depreciates more in the earlier years. The following table compares the depreciation amounts that would be available under these two methods, for a $1,000 asset that's expected to be used for five years and then sold for $100 in scrap.

As you can see, the straight-line method results in the same deduction amount every year, while the declining-balance method results in larger deductions in the first years and much smaller deductions in the last two years. One implication of this system is that if the equipment is expected to be sold for a higher value at some point in the middle of its life, the declining balance method can result in a greater taxable gain that year because the book value of the asset will be relatively lower.

Planning Tools You can download Form 4562, Depreciation and Amortization, used to figure depreciation and amortization, to aid in your financial planning.

To understand the depreciation rules and conventions that the IRS requires you to use for tax purposes, you need to know:

• Which assets can be depreciated?
• What is the depreciable value of an asset?
• Which assets can be expensed (written off) in the first year?
• How does the timing of your purchase affect depreciation?
• How can bonus depreciation rules increase your deductions?
• How do you depreciate assets that are not expensed?
• What special rules apply to cars and other listed property?
• When does depreciation end?
• How do you claim depreciation deductions on your tax return?
• What happens when you sell a capital asset?
• What about assets that are leased, not purchased?

Most people realize that if they claim more depreciation than they're entitled to, they may suffer penalties in a tax audit. What you may not know is that if you don't claim all the depreciation deductions that you're entitled to, you will still be treated as having claimed them when it comes time to compute your taxable gain or loss on the sale or disposal of the asset.

In some cases, the IRS gives you a choice between two or more different methods, but you must choose one of them — you can't create your own system. For example, you can't choose to depreciate your computer over three years, if the IRS mandates a five-year period, even though you may know your particular computer will be obsolete and replaced within three years.

Typically, if you make a mistake and claim the wrong depreciation amount, you can generally file an amended tax return (Form 1040-X) for the year at issue, and correct your deduction. However, if you make the same mistake for two or more consecutive tax years and the mistake is not a simple math error (for example, you realize that you've been using the wrong table), you've effectively chosen an accounting method, and you cannot correct the mistake by filing an amended return. Instead, you must file IRS Form 3115 requesting permission to change accounting methods.