Depreciation is a crucial tax concept that all entrepreneurs and business owners must understand. In this article you will learn which assets can be depreciated and which assets cannot be depreciated.
Depreciable and non-depreciable are two different types of assets that anyone looking to start a business should understand to precisely evaluate the potential earnings.
If you want to run your business correctly and have a pretty good profit estimate, you must understand the difference between the two and know which assets can be depreciated and which assets can’t.
Following our article will give you all the information you need to manage your accounting books successfully.
Which Assets Can Be Depreciated?
According to Cornell Law School official website, the assets that are used for generating income or profit and have a lifespan of at least one year are called depreciable assets.
They can be depreciated on your business’s taxes, meaning that the tax benefits of the expense will be spread out over many years. As these assets lose value over time, the business can continue receiving tax write-offs throughout its lifespan.
Examples of assets that can be depreciated
The business assets that can be depreciated come from property, including computers, furniture, vehicles, machinery, or entire buildings.
Other forms of depreciable business assets include intangible property such as computer software, copyrights, and patents.
When it comes to depreciable assets, the rules are dictated by the IRS (Internal Revenue Service).
To help businesses, the IRS has five rules for determining which assets are actually depreciable. They are:
- Something that a business owns;
- That is used in an income-producing capacity and in the business itself;
- That has a calculated lifespan;
- Lasts for at least a year;
- Something that is not included on the IRS list of “assets that do not qualify for depreciation”.
How do depreciable assets work?
First, a depreciable asset must be functional, ready, and available for usage from the get-go.
Even if you do not need the asset right away and it is still in the box next to your desk, it has to be functional immediately when required.
For example, if we are talking about a computer, once you plug it in and turn it on, ensure it works. After setting it up, how often you will use it is irrelevant.
Depreciation is the process by which the item loses its value while being used. Its usage reduces the initial cost of the asset.
The accumulated depreciation is shown in the final business statements at the end of the year. The last business statements also contain the initial cost of all the depreciated property.
The depreciating of a business asset can happen in two scenarios. One, if you sell the asset, and two, if it breaks down.
The asset’s lifespan, or how many months it has been useful in the business, depends on its class. For depreciation purposes, the IRS has limits.
For example, livestock and tractors have a lifespan of three years, furniture seven years, and commercial buildings 39 years.
Recommended read: How to Start a Business Online, from Home
Which Assets Cannot Be Depreciated?
You can’t depreciate assets you own and use for personal purposes, inventory, or assets held for investment purposes. Also, you can’t depreciate those assets that don’t lose their value over time.
There are also long-term assets that are non-depreciable such as land, investments, intangible assets, non-material assets, and personal items that belong to the employees of the company or the owner.
For instance, land can’t lose its value; therefore, it cannot be depreciated.
On the contrary, the soil loses its quality, and you can depreciate some costs that are related to the preparation of the land.
Assets bought and disposed of in the same year are also non-depreciable.
They are known as “current assets” and include prepaid insurance, business supplies, and the amounts owed to your business, also known as accounts receivables.
Lastly, another important thing we are going to mention which cannot be depreciated is cash holdings. As a result of inflation and deflation, the buying power may change over time, but the money keeps the same value. A $10 bill will always be worth $10 even if with it you cannot buy the same items as you used to.
Examples of assets that cannot be depreciated
Some examples of assets that cannot be depreciated are:
- Account receivables (what other businesses or clients owe your company);
- Investments such as stocks and bonds;
- Personal property that is not used for business;
- Leased property;
- Property that your company is not using to generate an income;
- Memorabilia collectibles like coins or a piece of art.
Why Do Assets Depreciate?
All fixed assets like vehicles and equipment are, without a doubt, the larger expenses of the company.
After a while, the items become outdated and need to be replaced without taking a toll on the business itself.
This is where depreciation comes in.
The assets are depreciated to calculate the recovery cost incurred over their lifespan.
Basically, this represents a sinking fund that replaces the used assets when the company needs to sell them.
Another great thing is the depreciation of the items lowers the taxable income and offers a reduction of the tax burden of a business.
That said, the entire process of depreciation is a non-cash expense that does not affect the cash balance or the firm’s cash flow.
After carefully reading our article, we are confident that you can tell the difference between which assets can be depreciated and which assets cannot be depreciated.
Every bit of information will be helpful when tax season comes. Hopefully, our article cleared some things up for you to better understand the entire process of depreciation.