How To Use Depreciation To Your Advantage

Most people consider depreciation to be a negative term that only indicates that something is losing its value. But for many savvy business owners, depreciation is actually a positive thing that can signal opportunity!

As you may know, fixed business assets such as computer equipment and vehicles are all susceptible to regular wear and tear. As business owners, we are allowed to depreciate or write off a fraction of the total cost of such assets over a specific period. 

These calculations are often performed for tax purposes and are a vital component of your company’s tax returns. 

Taxing authorities realize that buying new assets in the present inevitably has an immediate effect on cash flow, even though such assets can help you generate income in the long term. This is why businesses are often allowed to avail a tax credit for depreciation. 

In this article, we’ll learn what depreciation is and how you can use it to your advantage. 

Let’s begin!

How To Use Depreciation To Your Advantage

What is depreciation?

Depreciation is a type of business expense that lowers the value of any property or assets you carry. 

This depreciation expense translates to lower earnings on which a business’s taxes are based. 

In turn, this allows for a reduction in the total amount of taxes that your business has to pay. As a simple rule, the greater the depreciation expense, the lower your taxable generated income.

Note: When taking advantage of some of the benefits depreciation can provide, it is important to have a good credit score so you have access to capital if you need it. You can find out your credit score for free from ClearScore.

Depreciation has two primary aspects. The first is the reduction in the value of the asset over a period of time. The second is allocating and spreading out the original price of the asset throughout its useful life to help you save money on paying business taxes.

The time over which assets are depreciated is decided by how long they can be used for. Or in simple terms, it’s the item’s “useful life”. 

Each specific type of asset has a decided number of years over which it can be depreciated. For instance, the estimated useful life of a computer or laptop is roughly five years.

How depreciation can benefit your business

Everyone knows that most daily expenses in business are deductible because they are often necessary for the business to run. 

For example, if you purchase a bunch of office supplies for $100 in a year, you get a necessary tax reduction for that $100 of office equipment because you burnt out money on it during that year.

Depreciation allows you to get a deduction for assets or items in the current year, even though your business might not have spent money on buying it that year. 

For example, consider that you purchase a computer for your office in 2021 for $5,000 with an estimated useful life of around 5 years.

This means you get to write off the $5,000 over the next five years (taking the expense to lower your business’s taxes).

So even though you didn’t spend a single dollar on the computer in 2023, you will still get a deduction for that PC in that year. 

This is because you bought it two years ago and it is still being written off for 5 years from the date of purchase. Therefore, you are essentially getting a deduction in 2023 for a non-cash expense.

Depreciating assets also gives you more income on your profit-loss statements and increases your assets on your company’s balance sheet. 

The computer you bought in 2021 for $5,000 (minus the depreciation of $1,000 in the same year) causes an increase in your assets on balance sheets by $4,000. 

This is important because almost every third party investor likes seeing increased assets and net income over liabilities in a business’s financial statements.

What is accelerated depreciation?

Accelerated depreciation gives you the option to take greater depreciation in the first few years of an asset's useful life. 

Accelerating the depreciation on business assets allows you to deduct a greater percentage of the original price in the earlier years following purchase.

In some places, businesses are even allowed to deduct the original purchase price of an asset in its entirety during the tax year. 

This means business owners can deduct the complete purchase cost of the asset from their net income. You can also choose to avail bonus depreciation deduction for buying new assets.

The advantage of using accelerated depreciation

The biggest advantage of accelerated depreciation is that it allows business owners to get more of a tax deduction during the first few years after an asset’s purchase. This means you get an earlier return on more of your tax money versus getting it later on.

It is still worth realizing that depreciation is just a case of “now or later”. Sometimes, accelerated depreciation is better for your business while at other times it isn’t. 

Knowing when and how much depreciation to take over the useful life of an asset depends on the specific needs and circumstances of your business.

For example, if you are expecting to generate higher income in later years, it would be best to not accelerate the deduction and instead write off the property using straight-line depreciation (fixed depreciation/year). 

This can help save up deductions for the later years when your business is in a higher tax category.

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