Making sense of whether to expense or depreciate a business asset
Find out when you should either depreciate or expense a business asset including rules for bonus depreciation, with help from The Tax Institute.
Eureka! A small business owner has a brilliant idea for a product or service and chooses a suitable business entity. How tenacious! Before building a base of loyal customers, one of the business owner’s next tasks is buying all the things needed to operate the business. One of the first issues any business encounters is deciding whether to depreciate or expense a particular asset.
The Tax Code allows gross business income to be reduced by the costs of purchases that are used or consumed for the business, i.e. ordinary and necessary business expenses. Some business items are expensed while some items while other items may be depreciated. But what does that actually mean? Which method applies and how? Is one method more beneficial than the other? The types of deduction allowed depend mainly on the nature of the item, its cost, and when it was first placed in service.
What kinds of assets are deductible?
Depending on the business, nearly any kind of business asset is deductible if it meets the ordinary and necessary tests. For large purchases that will be owned for many years, such as buildings, the income reduction (deduction) is calculated using the depreciation method. For items that are used up in the business such as pens and paper, the reduction of income comes from expensing.
For small purchases of tangible items, there may be room to maneuver within IRS guidelines. For those purchases, the decision can be based on whether it’s more beneficial for the owner to depreciate the item or expense the item. Keep in mind that a taxpayer is required to claim all deductions allowed under the Tax Code, including depreciation.
How do businesses depreciate an asset?
When an asset is depreciated, the owner deducts part of the purchase cost each year. This deduction is reported annually on Form 4562, Depreciation and Amortization. Depreciation is also referred to as “capitalizing” or “recovering the basis.” Depreciation deductions are a delayed recovery of costs. The annual deduction is made each year for the useful “life” of the asset, as established by IRS rules. Depreciation may benefit a business owner whose income increases and pays a higher tax rate on net income in the years after the purchase.
Note: Certain assets can be deducted fully in the year of purchase under the bonus depreciation and Section 179 rules, discussed below.
What is the asset expense method?
“Expensing” means that the cost of the asset is entirely deducted from income in the same year that the item is purchased and used. Expensing is likely to benefit the business’s immediate cash flow.
Expensing applies to operating costs. Assets that can be expensed include small purchases of items that are used up (“consumed”) in the business. A tangible item that falls under “materials and supplies,” which generally are deducted in the first year it is used or consumed.
A “material” or “supply” is defined as tangible property that is not inventory for resale and meets one of the following criteria:
- Is a component acquired to maintain or repair a unit of property (UOP) that is owned, leased, or serviced by the taxpayer and that is not acquired as part of any single UOP;
- Is a UOP that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operations;
- Consists of fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in a taxpayer’s operations;
- A UOP with an acquisition or production cost of less than $200; or
- Any other tangible property identified in IRS guidance as a material or supply.
Schedule C, Form 1040, Profit or Loss From Business, is a good guide to the types of costs that the IRS considers to be daily operating expenses.
When do business owners have a choice to expense or depreciate assets?
There are two circumstances when the business owner has a choice whether to expense or depreciate an asset:
- When a purchase costs less than $2,500, it falls under the Safe Harbor for De Minimis Amounts; and can be expensed, even though the asset meets “materials and supplies” definition.
- When a purchase is of an item with a useful life of more than a year, it can be depreciated. In some instances, the depreciation may be a first-year deduction of the entire cost.
Example. A carpenter operates as a sole proprietor and reports on Schedule C, Form 1040. He buys a specialized table saw for $2,400, for business use.
Here are possible treatments for the table saw, whichever best suits the situation:
- Expense the asset under the Safe Harbor for De Minimis Amounts. In this case, he will claim the entire cost ($2,400) on his business return as an expense deduction, or
- Depreciate the asset. However, instead of the smaller deduction yielded by regular first year depreciation, instead consider bonus depreciation or section 179 deduction, described below.
Other factors to consider, besides the effect on cash flow?
Things to consider include:
- For the de minimis safe harbor, consider the annual requirement of an election;
- Bonus depreciation eligibility and the treatment of sale proceeds if the asset (the table saw in the above example) is sold;
- For the section 179 deduction, consider the recapture rules.
- The impact on the qualified business interest deduction (QBID);
Election to use the Safe Harbor for De Minimis Amounts
For purchases of tangible property and improvements to tangible property, the taxpayer can elect to deduct the cost up to $2,500 for each item (assuming the taxpayer does not have an applicable financial statement). In other words, the taxpayer can deduct the cost as an ordinary and necessary expense, rather than depreciate.
If the taxpayer elects to use the de minimis safe harbor method:
- The taxpayer cannot elect to depreciate some assets that meet the rules and deduct others. When the election is made, for all materials and supplies that meet the de minimis safe harbor rules, the taxpayer must use the de minimis safe harbor.
- The election is made by attaching a statement to a timely filed (including extensions) original tax return for the year in which the amounts are paid. The statement must be titled “Section 1.263(a)-1(f) De Minimis Safe Harbor Election” and include the taxpayer’s name, address, taxpayer identification number, and a statement that the taxpayer is making the de minimis safe harbor election under Reg.§1.263(a)-1(f).
- The election must be made annually.
- For any asset that is expensed, rather than capitalized, assuming the asset is eventually disposed of for an amount greater than its cost (basis), the gain is treated as ordinary income and is reported on Schedule C as self-employment income.
For more information on the de minimis safe harbor, see the Insights article "Revisiting the de minimis safe harbor tangible property regulations"
Bonus depreciation and treatment of sales proceeds
Qualifying business property, which includes the table saw from the example, is eligible for bonus deprecation. Under the Tax Cuts and Jobs Act, a 100% bonus depreciation rate is effective for most property placed in service after September 27, 2017 and before January 1, 2023. After that, the rate phases down through 2026. The cost may be expensed in the year that the qualifying business property is placed in service. Bonus depreciation is claimed on Form 4562, Depreciation and Amortization, Part II.
- When the asset is sold, the depreciation is recaptured to the extent of gain and taxed as ordinary income, but it is not reported on Schedule C and is not self-employment income.
- Gain over the amount of recaptured depreciation is reported as capital gain.
Section 179 deduction
For qualifying property, the section 179 deduction allows the entire purchase price to be deducted, to the extent of the income from the activity. The election may be made on the original return filed for the tax year by completing Part I of Form 4562, Depreciation and Amortization.
- The section 179 deduction is recaptured as ordinary income if, during the recovery period of an asset for which the deduction was claimed in a prior year, the percent of business usage subsequently falls to 50% or less.
- The recapture is reported as ordinary income on Schedule C, assuming that is where the deduction was taken, and the recapture income is thus self-employment income.
Interaction of the Section 179, Bonus, and Regular First-Year Depreciation Deductions
If the property qualifies for both bonus depreciation and the section 179 deduction, and the taxpayer elects to claim both:
- Section 179 deduction is computed first,
- Bonus depreciation is computed second, and
- Regular first-year depreciation deduction is computed third.
Impact on QBID
Depreciating property, rather than expensing it, may help a taxpayer who claims a QBID and is over the taxable threshold for the tax year in which the QBID is claimed. For 2019, the threshold is $160,700 ($160,725 if married filing separately or a married nonresident alien; $321,400 if married filing jointly.)
- For QBID, “qualified property” is tangible depreciable property used in the taxpayer’s U.S. trade or business operations.
- When assets have been expensed, those assets are not classified as depreciable property, and so they are not “qualified property” for the QBID.
Know the rules
The carpenter has some considerations and choices to make about the tax treatment of the purchase of an expensive tool. Now with each new business asset, he might consider whether to expense or depreciate that item. Suppose the carpenter also buys a building, a motor vehicle, and a computer? They are common purchases, but the rules - and the choices - will vary. It is important to check out the tax rules as they apply to other types of assets. Pub. 946, How to Depreciate Property, explains the depreciation rules. Pub. 535, Business Expenses, explains the expensing rules. Taxpayers, when possible, may make choices that maximize the benefit for their business situation.