Into the Depths of Depreciation...

For business owners, and business buyers, depreciation can appear as a dense swirling mist on a dark, chilly night. You can see it, obviously. You can feel it dampening your skin, but no matter how hard you stare, how you try to adjust your focus, you just can’t see through it. You know there are twists and turns in the path, maybe even hidden dangers, but you just can’t make them out. Recording the purchase of a piece of equipment for your business shouldn’t be this confusing!

But it is. Anything the government is involved in gets muddled up and it takes a team of diligent advisors to figure it all out. (Job security for people like me:-) Depreciation is a group of convoluted rules the government came up with, and of course changes every year or so, to determine how exactly you can write off “larger” business purchases of physical items. Amortization is pretty much the same thing for intangibles, or things that have value but you can’t hold in your hand. Same concept-Different rules.

In this chat, we’ll de-mist-ify depreciation and talk about:

• What expenditures need to be depreciated?

• What are the available options to choose from when depreciating an asset?

• How do you read a depreciation schedule?

• What is the relationship between cash and depreciation?

What Expenditures need to be depreciated?

The first thing we look at is the size of the expenditure. If you bought a tool or a desk or a laptop that cost less than $2500, just expense it immediately. That means it reduces your taxable income in the time period you purchased it. Anything over $2500 requires some thought. What exactly was that transaction about?

If it turns out it was for a repair and maintenance bill, no big deal. Again, you can deduct the whole amount right now, regardless of the size of the transaction. Repairs and maintenance items are things you need to do on a regular basis to keep that machine running as it was intended. An oil change and tune up for a farmer’s combine can easily run $10,000, but it's a routine maintenance item so write it off immediately. Replacing a blown hydraulic hose gets deducted now, too.

If that $2500 or larger amount was for an equipment purchase, or an equipment improvement, it needs to be listed on your asset schedule and depreciated, or written off over time.

Determining an equipment improvement is one of the denser areas in that misty fog of depreciation. Something that makes the equipment bigger and/or better is not a repair; it would be classified as an improvement. I always use the pickup truck example. If you take a Ford F150 and put new tires on it, change the oil, replace the power steering belt, that’s regular maintenance that must be done to keep the ruck operating as it was intended. If you replace the standard bed with a dump bed, that is not a repair. You now have a truck that is better than it was before, one that can do much more than a standard pickup, so it’s an improvement. Repair equals current expense. New and/or improved equipment equals depreciation and deducting over time.

What are the available options to choose from when depreciating an asset?

For conversational purposes, we’ll say you have three depreciation choices.

1. Regular depreciation is the standard choice. The IRS has determined how many years it takes to write off or fully expense every piece of equipment you could buy. If you bought a tractor for $100,000, it probably has a depreciable life of 7 years. This is not saying your tractor will only last 7 years. It means the $100K you spent on the tractor will be divided out over 7 years, reducing your taxable income a little bit every year.

Skip the italic parts unless you want to be a depreciation nerd.

Surprise! It’s not divided evenly over 7 years. That would be straight-line depreciation. The normal formula used in most instances is the double declining balance method. It allows for the largest deduction in the first year, then it decreases every year after that until it’s zero. It’s actually twice the rate of the straight-line method and thus it's name.

2. Bonus depreciation is another option and one the government changes frequently. Last year, bonus depreciation would allow you to write off or deduct the full expense at the time of purchase. In 2023, it allows for the immediate write-off of 80% of the asset purchase price. And the following year it will be 60%. And so on and then who knows what they'll come up with.

More italics for my fellow nerd-types. This method used to be reserved for brand new equipment only. Bonus depreciation is now available for used purchases as well.

3. Sec 179 is your third option. This also allows you to write off the entire $100k tractor at the time of purchase, with a caveat: you must have profit, enough profit to “absorb” that depreciation expense. To take the full Sec 179 deduction on the tractor purchase, you must have $100K of profit prior to making this choice. If you only have $50K of profit, you could use Sec 179 for half of the tractor and use regular depreciation for the remaining half, or any other combination that meets the profit rule. There are other rules pertaining to the profit requirement, but I’m not even going to put those in italics.

CAUTION. Each state makes its own rules on Sec 179 and bonus depreciation. For example, the last time I checked, Indiana only allowed for $25K of Sec 179 per year. Not being aware of your state’s rules could result in little to no federal income (yippee!) but an unexpectedly large state income, which of course could mean a surprise tax bill too.

How do you read a depreciation schedule?

Let’s look at the sample depreciation schedule below. This was taken from a business tax return. It happens to be for a trucking company.

Start at the top left in the photo and follow along. Form 4562 is the tax form for depreciation. Under Depreciation Detail you should see asset 1, a 2005 Freightliner. Follow that across to the right and we’ll know all there is to know about this truck, at least as far as depreciation goes. This Freightliner was purchased on November 20, 2017, not a brand new machine. (Depending on the changing landscape of bonus depreciation, new and used equipment may be treated differently.) The vehicle was bought for 100% business purposes. The purchase price was $16,000. It’s being depreciated over 5 years, referred to here as the Recovery Period. Prior to the date of this statement, $14,549 of depreciation had been taken, as shown under Prior Accumulated Depreciation. The current depreciation taken for the year of this statement, 2022, was $1451. Add that to the previous year’s depreciation and you get a total depreciation of $16,000. This is also the total purchase price for the truck, so it is now fully depreciated.

If you were to buy this business through a stock sale transaction, you would pick up depreciation where the previous owner left off. For this asset, there would be no depreciation left for you, the buyer, to take.

Go back to the left and find the next asset, which happens to be number 5. The 2013 Freightliner was purchased on May 1, 2019, a used asset, for $46,000. Again, 100% business use and a 5 year life. Prior to this report, $32,752 of depreciation had been taken. This year, the depreciation expense is $5299. In other words, of the total price tag for this asset, only $5299 can be used to reduce this year’s taxable income. And that brings the total depreciation for the 2013 Freightliner up to $38,051, leaving $7941 for the next year and a half.

If you were to buy this business through a stock sale, you would be able to continue on with that same schedule, picking up where the seller left off. If you were to buy this business through an asset sale, part of your sale price would be allocated to these trucks. The buyer’s depreciation starts from scratch, based on the agreed upon allocation.

Next we’ll take a look at asset number 14, near the middle of the page. A Mercedes was bought on September 17, 2022 for $268,079. This is very different from all the other business assets, a suspicious break in pattern. From cheap, used Freightliners to a super expensive Mercedes? In performing due diligence on this acquisition, I definitely want to know why this truck was purchased.

Following the Mercedes across to the right, you will see the entire purchase price is under Special Allowance. This truck was depreciated immediately through bonus depreciation. (Scroll back for an explanation of bonus depreciation.) The total purchase price was used to reduce taxable income in 2022. (We're going to skip the fact that a few of these vehicles are categorized as Listed Property.)

Check out the bottom of the schedule and you’ll see the total purchase price for all the assets currently owned by this trucking company is $818,879. The current depreciation expense for 2022 is $91,714. Total depreciation taken so far is $685,920, with about $132,000 left to go. The most recently purchased assets were bought in 2021 and 2022 so there are still a few years left to depreciate those.

What is the relationship between cash and depreciation?

There isn’t one. Depreciation is not a cash expense. Depreciation doesn’t have anything to do with the movement of the money. Back to that $100,000 tractor purchase. If you finance the entire purchase, you now have a tractor and a loan, but your checking account is unchanged. If you are able to take one of the immediate depreciation methods, you will also have a $100K current expense, reducing your income right now, and your cash is still unaffected. Sounds like a win/win, right?

It is…until it comes time to make all those loan payments. You’ll be spending lots of cash paying off the loan, plus interest. And here’s the catch. Only the interest portion of the loan payment is a deductible expense. The principal portion, the $100K, was already deducted through the depreciation expense. If that is a ten-year loan, you’ll be making payments, and spending cash, for 10 years with no additional deduction except the interest portion. That may take a minute to sink in... It often catches business owners by surprise and is one reason you may have an empty bank account and a fat tax bill.

I hope this conversation provided a bright light to clear up some of the fogginess of depreciation. I tried to keep it simple while providing enough detail to give you a high-level understanding. Bottom line? Depreciation is a non-cash expense that you can use to juggle the level of profitability you want to show. It also can play a significant role in negotiating a business buy-sell deal.

Reply back with any questions you may have:-)