Small Business Tax Preparation Guide

5. The Ultimate Guide To Tax Depreciation

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Business Finance

The Ultimate Guide To Tax Depreciation

Apr 28, 2023 • 10+ min read
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      When it comes to your small business taxes, everyone wants to find a way to lessen their tax burden. The easiest way to do just that is by having a keen understanding of depreciation and its effect on your business and assets. 

      Unfortunately, depreciation isn’t a single-solution sort of problem. There are many ways to use depreciation to reduce your business taxes, so it’s important for you to have a solid understanding of the options and how they can help your business.

      What Is Tax Depreciation?

      Tax depreciation is the depreciation expense on a tax return where your business recovers the cost of a business asset (Ex: machinery) over the useful life of the asset taking into account allowance for deterioration, wear and tear, or obsolescence.

      Tax Depreciation Methods

      When you start the process of deducting depreciation for your taxes, you need to understand your options. There are four depreciation methods: straight-line, double declining balance, MACRS, and Section 179. 

      While straight-line and double declining balance are preferred for financial statement reporting because they are in accordance with GAAP, MACRS and Section 179 are not. MACRS, however, is the primary tax depreciation method used since 1986 with the IRS for taxes. Read on below to understand each method.

      Straight-Line Depreciation 

      If you like consistency and predictability, a straight-line depreciation method might be for you. True to its name, this method means your annual calculations and deductions will be consistent from start to finish. Additionally, if you know your property won’t be overused early on and will depreciate consistently (like office furniture, appliances, or livestock), the straight-line method is likely a safe bet.

      To figure out your yearly depreciation cost in this method, you need to subtract the salvage value of the property/asset from its original purchase amount. From there, you’ll divide that number by the useful life of the item. For example:

      $50,000 (purchase amount) – $2,000 (salvage value) /10 years = $4,800 (annual depreciation amount)

      Keep in mind, whatever piece of property you use for your calculations likely fits into a specific, IRS-determined, year-based category. But don’t worry—we’ll cover those a little later.

      Double-Declining Balance

      Where the straight-line depreciation method is simple and predictable, a double-declining balance method gets more complicated. Instead of deducting the same amount every year, this accelerated depreciation method means writing off a large chunk of the property cost early on and then a decreased amount thereafter. The double-declining balance method might be a great option for determining depreciation for a new work truck purchase where you know it will see some heavy use right away. 

      The calculation used for a double-declining balance depreciation method utilizes some of the same information you had for your straight-line depreciation calculations. So once you’ve established your asset cost (or purchase amount for the first-year calculations), its salvage value, and useful life, you’re ready to plug the information into the following equation:

      2 x (Asset Cost – Salvage Value) / Useful Life of the Asset = Your Yearly Depreciation Amount

      Unfortunately, because the depreciation amount is supposed to change over the years for this method, you’ll need to repeat the calculations annually, but with a different asset cost. Each year you calculate depreciation, your asset cost subtracts the amount you wrote off last year from the current cost. To make this a bit easier to understand, here are a few examples.

      Year 1:

      2 x ($50,000 – $2,000) / 10 years = $9,600

      *$50,000 was the original price of the asset and $2,000 is the salvage value.

      Year 2:

      2 x (($50,000 – $9,600) – $2,000) / 10 years = $7,680

      *$50,000 – $9,600 (or $40,400) is the value of the asset after the previous year’s write-offs are deducted. $2,000 is—and will remain—the salvage value.

      Year 3:

      2 x (($40,400 – $7,680) – $2,000) / 10 years = $6,144

      Modified Accelerated Cost Recovery System (MACRS)

      MACRS depreciation was introduced in 1986 to encourage the purchase of long-term assets where the buyers could get large tax savings in the earliest years of the asset’s life and less in the later years.

      From the tax perspective, MACRS is better than many other methods, as most assets are most productive in the initial years and tend to deteriorate in the later years.

      However, the MACRS method is not approved by GAAP and, thus, is not used in the preparation of the balance sheet or audited financial statements. The method doesn’t take into account the salvage value or the asset’s useful life and, thus, is used only on the tax return.

      MARCS refers to the calculation methodology that determines this annual deduction. Two distinct calculation methods fall under the MACRS umbrella: General Depreciation System (GDS) and Alternative Depreciation System (ADS). GDS is the default MACRS method, as it helps recover costs faster than ADS.

      MACRS Methods

      There are three methods within MACRS (GDS). Which method you use will depend on the useful life of the asset as defined by the IRS: 

      • 200% or Double Declining Balance Method: Assets will depreciate at double the straight-line depreciation rate.
      • 150% Declining Balance Method: Assets will depreciate at 1.5x the straight-line depreciation rate. 
      •  Straight-Line Method 

      MACRS (ADS) uses Straight-line only.

      How To Calculate

      To properly calculate MACRS depreciation, take the following steps:

      1. Determine the basis – This is the cost of the asset, plus anything paid to get it ready for use (Ex: installation).
      2. Determine the property’s class – MACRS organizes assets into different classes based on their useful life. IRS Publication 946 can be helpful at this step, as it provides a list of asset categories, including:
        • 3-year property: tractors 
        • 5-year property: vehicles, computer equipment, office machinery, cattle, and appliances used in a residential rental property
        • 7-year property: office fixtures and furniture
        • 10-year property: agricultural establishment
        • 15-year property: land improvements and tenant improvements
        • 20-year property: municipal sewers
        • 27.5-year property: residential rental properties
        • 31.5-year property: non-residential real property
      3. Determine the depreciation method – For MACRS (GDS) for three-year, five-year, seven-year, and 10-year, you would use the 200% double declining balance method. For MACRS (GDS) 15-year and 20-year, it is the 150% declining balance method. For MACRS (GDS) 27.5 and 31.5, it is Straight-line.
      4. Determine the date it was put into service – “In service” refers to when the asset was ready and available to be used. There are three possible conventions you can apply here:
        • Mid-month convention – This convention starts depreciating all property placed in service during the month at the midpoint of the month. For example, a property purchased January 30 can be depreciated for a full half-month.
        • Mid-quarter convention – This starts depreciating all property placed in service the last three months of the year, unless you must use the mid-month convention.
        • Half-year convention – This convention starts depreciating all property placed in service during the tax year as of the year’s midpoint. An example is purchasing the property in January, but getting a full half-year of depreciation. This method is used only if the property doesn’t require using the Mid-Month or Mid-Quarter.
      5. Use the following computation to calculate your asset’s depreciation

      1st Year Depreciation = Basis x (1 / Useful Life) x Depreciation Method x Depreciation Convention

      In subsequent years, the formula to use would be:

      Subsequent Years Depreciation = (Basis – Depreciation in Previous Years) x (1/Useful Life) x Depreciation Method


      Let’s say you buy a piece of furniture in February for 5,000 and the half-year convention applies. Furniture is a seven-year property class, and the 200% double declining method applies.

      The formula would be:

      $5,000 X (1/7) X 200% X .5 = $714.29

      The following year, depreciation expense for the computer would be:

      (5,000 – 714.29) X (1/7) X 200% = $1,224.49

      Section 179

      As probably the most straightforward depreciation method, the Section 179 method allows you to deduct the entire cost of your property within its first year of use. It’s a great solution if you don’t want to worry about calculations or repeating the depreciation process over the life of your property.

      As simple as that may seem, there are some limitations. Estates and trusts, for example, can’t use a Section 179 deduction method. But there are additional rules involving the allowed deductible amounts in regards to property type and much more. Make sure you do your research to ensure you use this depreciation method only on the appropriate assets.

      Which Assets Depreciate?

      Have you ever asked yourself, “Can I write off my _____?” or “Are my office supplies depreciable?” Given how confusing taxes and anything government-related can be, it’s no surprise that many people feel a little lost and overwhelmed. Thankfully, the IRS provides a webpage (albeit a lengthy one) that details everything you need to know about how to depreciate property. 

      Instead of expecting you to read through more than 100 pages and 50,000 words of legalese, we’ve gone ahead and found the most important parts and pulled them out for you. You’ll notice the IRS divides the items into year groupings. That signifies the number of years over which those assets can depreciate.

      Three-Year Property

      • Over-the-road tractor units
      • Horses and racehorses
      • Qualified rent-to-own property, including: computers and peripheral equipment, televisions, stereos, camcorders, appliances, furniture, washing machines and dryers, refrigerators, and other similar property

      Five-Year Property

      • Automobiles, taxis, buses, and trucks
      • Any qualified technological equipment
      • Office machinery (Ex: copiers)
      • Breeding cattle and dairy cattle
      • Appliances, carpets, furniture, etc., used in a residential rental real estate activity
      • Certain geothermal, solar, and wind energy property
      • Any machinery equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement items) used in a farming business

      Seven-Year Property

      • Office furniture and fixtures (such as desks, files, and safes)
      • Used agricultural machinery and equipment, grain bins, cotton ginning assets, or fences used in a farming business (but no other land improvements)
      • Railroad track
      • Any property that does not have a class life and has not been designated by law as being in any other class
      • Certain motorsports entertainment complex property
      • Any natural gas gathering line

      10-Year Property

      • Vessels, barges, tugs, and similar water transportation equipment
      • Any single-purpose agricultural or horticultural structure
      • Any tree or vine bearing fruits or nuts
      • Qualified small electric meter and qualified smart electric grid system

      15-Year Property

      • Any retail motor fuel outlet, like convenience stores
      • Any municipal wastewater treatment plant
      • Initial clearing and grading land improvements for gas utility property
      • Electric transmission property (that is a section 1245 property) used in the transmission at 69 or more kilovolts of electricity
      • Any natural gas distribution line
      • Any telephone distribution plant and comparable equipment

      20-Year Property

      • Farm buildings (other than single-purpose agricultural or horticultural structures)
      • Initial clearing and grading land improvements for electric utility transmission and distribution plants

      25-Year Property

      • Property that is an integral part of the gathering, treatment, or commercial distribution of water, and that, without regard to this provision, would be 20-year property
      • Municipal sewers
      • Residential rental property
      • Nonresidential real property (section 1250 property), such as an office building, store, or warehouse

      It’s Time to Tackle Your Taxes

      Now that you have a better understanding of which assets depreciate and how to calculate depreciation for your small business assets, you’re ready to go forth and conquer your year-end taxes.

      About the author
      Dana Wall

      I am a director-level Accounting and Finance Professional with over 20 years of progressive experience in the Entertainment industry. My career has allowed me to lead all accounting actions for large organizations, including month-end close, budget analysis, and internal controls. I am a CPA with a MBA from the University of California, Irvine.

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