Every business owner knows that assets lose value over time. They also know that purchasing a new asset today can have an immediate impact on cash flow even though it will likely help in the long run. The Internal Revenue Service (IRS) understands this as well, which is why it allows business owners to claim a tax credit for depreciation. Before you can do that, however, it’s important to understand what depreciation means.
Definition of Depreciation
Depreciation is a business expense that reduces the value of an asset you carry. You have a few options to consider when it comes to claiming asset depreciation on your taxes. If you opt for depreciation accounting, it means that you allocate the cost of your business asset over a period of years. You can find data to support your depreciation credit on the balance sheet, cash flow statement, or income statement for your business. The purpose of depreciation is to spread the expenses associated with a fixed asset over several years to help you save money on business taxes.
More About Depreciation Accounting
You must make several accounting entries if you choose the method of depreciation accounting. If you purchased the asset on credit, the initial accounting entry would reflect the first payment towards accounts payable while you would allocate the remainder of the payments as a fixed asset account debit. For assets paid in full upfront, you need to enter it as a debit for the full value as well as a payment credit. Each accounting entry for depreciation should include a debit for the expense and a credit for the accumulation of fixed assets.
Accounting for the Asset on Financial Statements
You should initially record the purchase of cash assets on a balance sheet as an asset transfer. Since this is a fixed asset and not cash, it will naturally lose value. Because of this, you need to reduce its carrying value gradually. When recording an asset on the income statement, you should show it as an indirect operating expense. This reduces your gross taxable profits.
Depreciation in Real Estate
Of all business assets, claiming depreciation for real estate can get a bit tricky. Before you can claim the credit, you must ensure that you meet each of these criteria:
- Submit proof that you own the property.
- You use the property as a revenue source. That means your family home doesn’t qualify.
- You cannot depreciate the land that the property sits on.
- You cannot depreciate a property that has a useful life of less than one year.
Additionally, you should obtain an accurate estimate from a real estate professional when assessing the value of your revenue-generating property. Estimating the property too high could mean you need to pay additional taxes on it later while estimating too low means you won’t receive the full value of the depreciation credit. Keep in mind that the IRS uses different rules depending on whether you purchased the property as a rental or strictly as an investment.
Need More Input on Depreciation?
We understand that depreciation of business assets can be a complex topic. If you would like to go over it in more depth or have questions about claiming depreciation on your business tax return, please contact Nolan Accounting for an appointment. We look forward to helping you maximize the bottom line.