Definition and types of Depreciation

1. DEPRECIATION
Bryce Warnes — Reviewed
by Janet Berry-Johnson,
CPA on January 20, 2022

2. WHAT IS DEPRECIATION? AND HOW DO YOU CALCULATE IT?
Depreciation isn’t a nice word. It sounds like the opposite of “appreciate” which is weird
because you’ll probably appreciate all the tax savings it will give you!
Even if you defer all things depreciation to your accountant, brush up on the basics and make
sure you’re leveraging depreciation to the max.

3. WHAT IS DEPRECIATION?
Depreciation is the process of deducting the total cost of something expensive you bought for
your business. But instead of doing it all in one tax year, you write off parts of it over time.
When you depreciate assets, you can plan how much money is written off each year, giving
you more control over your finances.
The number of years over which you depreciate something is determined by its useful life
(e.g., a laptop is useful for about five years). For tax depreciation, different assets are sorted
into different classes, and each class has its own useful life. If your business uses a different
method of depreciation for your financial statements, you can decide on the asset’s useful life
based on how long you expect to use the asset in your business.
For example, the IRS might require that a piece of computer equipment be depreciated for five
years, but if you know it will be useless in three years, you can depreciate the equipment over
a shorter time.

4. WHAT IS AN ASSET?
An asset is anything with a dollar value. The IRS also refers to assets as “property.” It can be
either tangible or intangible.
A tangible asset can be touched—think office building, delivery truck, or computer.
An intangible asset can’t be touched—but it can still be bought or sold. Examples include a
patent, copyright, or other intellectual property.
Both tangible and intangible assets can be depreciated. In the case of intangible assets, the
act of depreciation is called amortization.

5. WHAT KIND OF ASSETS CAN YOU DEPRECIATE?
The IRS sets guidelines for what types of assets you can depreciate. It needs to meet the following criteria:
 You own it
 You use it in your business, or to produce income
 You can determine its useful life
 You expect it to last more than one year
Some common examples of assets depreciated by small businesses include:
 Vehicles
 Real estate
 Equipment
 Office furniture
 Computers

6. WHAT IS A DEPRECIATION SCHEDULE?
A depreciation schedule is a table that shows you how much each of your assets will be depreciated over the years. It typically includes the following
information:
 A description of the asset
 Date of purchase
 The total price you paid for the asset
 Expected useful life
 Depreciation method used
 Salvage value–how much you can sell it for once it’s past its useful life (e.g., how much a scrapyard would pay for your old work truck)
 The depreciation amount deductible in the current year
 The cumulative depreciation amount
 The resulting net book value of the asset (total price paid minus any cumulative depreciation)

7. TYPES OF DEPRECIATION
There are several ways to depreciate assets for your books or financial statements, but the amount of depreciation expense on your books or financial
statements may not be the same as what you deduct on your tax return. As a result, some small businesses use one method for their books and another
for taxes, while others choose to keep things simple by using the tax method of depreciation for their books.
Let’s look at the options available for book and tax.
• Straight-line depreciation
What it is: The most common (and simplest) way to depreciate a fixed asset is through the straight-line method. This splits the value evenly over the useful
life of the asset.
Who it’s for: Small businesses with simple accounting systems that may not have an accountant or tax advisor to handle their taxes for them.
Formula: (asset cost – salvage value) / useful life
How it works: You divide the cost of an asset, minus its salvage value, over its useful life. That determines how much depreciation you deduct each year.
Example:
Your party business buys a bouncy castle for $10,000. Its salvage value is $500, and the asset has a useful life of 10 years.
We plug those numbers into the equation:
Formula: (asset cost – salvage value) / useful life
(10,000 – 500) / 10 = $950
So, you’ll write off $950 from the bouncy castle’s value each year for 10 years.

8. TYPES OF DEPRECIATION
• Double-declining balance depreciation
What it is: The double-declining balance method is a slightly more complicated way to depreciate an asset. It lets you write off more of an asset’s value in the days immediately after you buy it and less later on.
Who it’s for: Businesses that want to recover more of an asset’s value upfront because the asset loses value quickly in the first few years of ownership.
Formula: (2 x straight-line depreciation rate) x (book value at the beginning of the year)
How it works: For this approach, in the first year you depreciate an asset, you take double the amount you’d take under the straight-line method. In subsequent years, you’ll apply that rate of depreciation to the asset’s remaining book value
rather than its original cost. Book value is the asset’s cost minus the amount you’ve already written off. The double-declining balance method doesn’t take salvage value into account.
Example:
We’ll use the bouncy castle example for straight-line depreciation above.
Since the asset is depreciated over 10 years, its straight-line depreciation rate is 10%.
In year one of the bouncy castle’s 10-year useful life, the equation looks like this:
Formula: (2 x straight-line depreciation rate) x book value at the beginning of the year
(2 x 0.10) x 10,000 = $2,000
You’ll write off $2,000 of the bouncy castle’s value in year one. Now, the book value of the bouncy castle is $8,000.
So, the equation for year two looks like:
(2 x 0.10) x 8,000 = $1,600
So, even though you wrote off $2,000 in the first year, by the second year, you’re only writing off $1,600. In the final year of depreciating the bouncy castle, you’ll write off just $268. To get a better sense of how this type of depreciation works,
you can play around with this double-declining calculator.

9. TYPES OF DEPRECIATION
• Sum-of-the-year’s-digits depreciation
What it is: Sum-of-the-year’s-digits (SYD) depreciation is another method that lets you depreciate more of an asset’s cost in the early years of its useful life and less in the later years.
Who it’s for: Businesses that want to recover more of an asset’s value upfront—but with a slightly more even distribution than the double-declining balance method allows.
Formula: (remaining lifespan / SYD) x (asset cost – salvage value)
How it works: To calculate SYD depreciation, you add up the digits in the asset’s useful life to come up with a fraction that will apply to each year of depreciation. For example, the SYD for an asset with a useful life of five years is 15: 1 + 2 + 3
+ 4 + 5 = 15.
You divide the asset’s remaining lifespan by the SYD, then multiply the number by the cost to get your write off for the year. That sounds complicated, but in practice it’s pretty simple, as you’ll see from the example below.
Example:
Sticking with the bouncy castle example, it costs $10,000, has a salvage value of $500, and will depreciate over a 10-year useful life. For the castle’s 10-year useful life, adding up the digits would look like this: 1+2+3+4+5+6+7+8+9+10 = 55
The first year you depreciate using the SYD method, your equation will look like this:
Formula: (remaining lifespan / SYD) x (asset cost – salvage value)
(10 / 55) x (10,000 – 500) = $1,727
So, for your first year, you’ll write off $1,727.
Keep in mind, each year, the bouncy castle’s remaining lifespan is reduced by one, So, in your second year of depreciation, your equation will look like this:
(9/55) x (10,000 – 500) = $1,555
In your last year of depreciation, you’ll write off $173. Play around with this SYD calculator to get a better sense of how it works

10. TYPES OF DEPRECIATION
• Units of production depreciation
What it is: The units of production method is a simple way to depreciate a piece of equipment based on how much work it does. “Unit of production” can refer to either something the equipment creates–like widgets–or to the hours it’s in
service.
Who it’s for: Small businesses writing off equipment with a quantifiable, widely accepted output during its lifespan (e.g., based on the manufacturer’s specifications) who want to take more depreciation in years when they use the asset more
and less depreciation when they use the asset less. Because this method requires tracking the use of the equipment, it’s generally only used for high-value equipment or machinery.
Formula: (asset cost – salvage value) / units produced in useful life
How it works: Using the formula above, you figure out the dollar value in depreciation for each unit produced. By adding up all the units produced in one year, you get the amount to write off. Once all of the units have been written off,
depreciation of the asset is complete–its useful life is technically over, and you can’t write off any more units.
Example:
Since hours can count as units, let’s stick with the bouncy castle example.
Remember, the bouncy castle costs $10,000 and has a salvage value of $500, so its book value is $9,500.
Let’s say that, according to the manufacturer, the bouncy castle can be used a total of 100,000 hours before its useful life is over. To get the depreciation cost of each hour, we divide the book value over the units of production expected from
the asset.
9,500 / 100,000 = 0.095
So that’s an hourly depreciation of $0.095.
In its first year of use, the bouncy castle is bounced upon for a total of 12,000 hours. So our equation would look like this:
12,000 x 0.095 = $1,140
We can write off $1,140 of depreciation for the first year.
That number will change each year. Remember, you can write off a total of $9,500, or 100,000 hours. Learn more about this method with the units of depreciation calculator.

11. TYPES OF DEPRECIATION
•Modified accelerated cost recovery system
What it is: The Modified Accelerated Cost Recovery System (MACRS) is the depreciation
method generally required on a U.S. tax return. Under MACRS, assets are assigned to a
specific asset class, and that class determines the asset’s useful life. Double Declining
balance and Sum of the Years’ Digits methods are examples of MACRS depreciation. You can
find a detailed table of asset classes in IRS Publication 946, Appendix B.
A summary of the MACRS tables
Asset Class
Useful Life
(Years)
Types of Assets
3-year property 3 Tractors, qualified rent-to-own property
5-year property 5 Vehicles, computers, office equipment, research equipment, appliances for a rental property
7-year property 7 Office furniture and fixtures, farm equipment, any assets that don’t fit into other classes
10-year property 10 Boats, single-purpose farm structures
15-year property 15 Land improvement (landscaping, roads, and bridges)
20-year property 20 Multiple-purpose farm structures
Residential rental
property
27.5 Any rental property where 80% of its rental income is from residential dwellings
Non-residential rental
property
39
Office buildings, stores or warehouses that aren’t residential property, or which fit into
other classes

12. TYPES OF DEPRECIATION
•Modified accelerated cost recovery system
Who it’s for: Any business or rental property owner that claims depreciation expense on a
U.S. federal income tax return.
How it works: Calculating MACRS depreciation can be complicated. IRS Publication 946,
Appendix A includes three different tables used to calculate a MACRS depreciation deduction.
Rather than try to learn all the intricate details, it’s a good idea to let your tax software or
accountant handle the calculations for you. You can also check out this MACRS depreciation
calculator.