IRS Depreciation Methods

IRS Depreciation Methods

IRS Depreciation Methods

How to Start in an Online Business

Phase 2 – Step 8

 

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IRS Depreciation Methods

IRS Depreciation Methods

Hello again. I hope all is well. If you have been going through my step-by-step process for setting up your Online Affiliate Marketing Business and have reached this point, you are doing very well. Please continue.

In this post I will be discussing the various IRS Depreciation Methods. You will need to know these and understand them in order to complete your 2nd Spreadsheet. Each Method will have pros and cons, so by understanding these options, it will make it easier to choose the one that will work best for you.

 

First, let’s identify exactly what Depreciation is, along with a few other related terms:

    • Depreciation is the amount or percentage by which an Item or Asset decreases in value over time, usually computed each year.
    • Assets are valuable items that are useful and contributes to the success of something (like your business).
    • Expenses are the costs spent in order to purchase something.
    • Expenditures are the amount of money that somebody spends for business purposes that is Deductible from Income Tax.
    • Income is the amount of money received over a period of time as payment for work, goods, or services provided.
    • Debits are an entry in an accounts record showing a debt or Expense.
    • Credits are amounts of money paid into an account.

 

So, in a nutshell:

    • Income equals Credits and each source will be entered as a Credit in your Books.
    • Expenses equal Debits and will be listed as a Debit in your Books.
    • Expenses become Expenditures when they are Tax Deductible. Assets are the items that your business owns.
    • Depreciation is the decreasing value of an Asset over time.

 

You get Taxed on the amount of Income that you earn, minus the Expenditures that you have in your business. Depreciation is one of these Expenditures and can be computed in several different ways. However, there are only two that will generally apply to an Online Affiliate Marketing Business. They are as follows:

 

1. Straight-Line Method

 

This Method is the most commonly used and simplest. For each Asset, the purchase Cost will be divided by the expected Life Span, and the same amount is Depreciated each year and listed as a Deduction on your Tax Return.

Using this Method requires you to take into account the Salvage Value of what each Asset will be worth at the end of it’s Life Span. You would deduct this amount from the Cost of your Asset before calculating your Depreciation Deductions.

Your Depreciation Deductions for the 1st year, are limited to the portion of year that you are in business.

 

Example:  If you have an Asset that you purchased for $500, with a Life Span of 5 Years, and a Salvage Value of $0, your normal Deduction, using the Straight-Line Method would be $100 for each of the 5 Years. However, if you started your business on Sept. 12, you would have only been in business for 1/3 of the year (you would count Sept., since it is more than 1/2 of the month). Therefore, your 1st Year Deduction for that Asset would be $33 (1/3 of $100). Even though your Asset has a Life Span of 5 Years, you will have a remaining value at the end of that 5th Year, due to your smaller allowed Deduction in Year 1. You would therefore, take the remaining Deduction for that Asset in the 6th Year.

 

2. Accelerated Method – Accelerate Cost Recovery System

   (ACRS) / (MACRS – Modified)

 

This Method is used by many small businesses, but it is much harder to calculate and may not always be the best to use. It lets you take a larger Deduction in the first few years and a smaller write-off later. While this may sound appealing if you are strapped for cash during your beginning years in business, when you start making some really good money down the road, your Deductions will be much smaller, causing you to pay more Taxes then, possibly even causing you to be in a higher Tax Bracket.

While there are variations of this Method, the most commonly used for an Online Affiliate Marketing Business would be the 200% Declining Balance Method using the Half-Year Convention, which means that the Deduction that would otherwise be allowed for the 1st Year is halved, regardless of what month you started using the Asset in your business, and that remaining half will be deducted in the 6th Year.

(However, if more than 40% of all property is placed in service during the last three months of the year, you can not use the Half-Year Convention, and must use the Mid-Quarter Convention Tax Tables instead. It is generally a good idea to avoid the Mid-Quarter Convention since it offers less Tax Deductions during the first year.) However, you can compensate for this by using the Section 179 Expense Deduction (discussed below).

 

Sounds confusing, I know. However, the IRS has Tax Tables to assist you in calculating. Here are the logistics of MACRS using the 200% Declining Balance Tax Table:

    • You do not have to take Salvage into account, as you do with the Straight Line Method.
    • Generally you would use the ‘Half-Year Convention’.
    • MACRS Depreciation starts off at 200% of the Straight-Line Method rate and then switches over to the Straight-Line Method, when that Method provides an equal or greater Deduction.

 

An Example

 

Let’s compare the Deductions for each of the Methods using a sample Asset with the following parameters: Cost – $500, Life Span – 5 Years, Salvage Value – $0, and starting your business on August 18th (1/3 of the year):

 

Straight-Line Method Deductions

    • Year 1: $33
    • Year 2: $100
    • Year 3: $100
    • Year 4: $100
    • Year 5: $100
    • Year 6: $67

 

Accelerated Method (MACRS – 200% Declining Balance – Half-Year Convention)

The following percentages are from the IRS Tax Tables, and are used for easier calculations. They are based on the initial Cost of the Asset (rather than the Declining Balance) and take into account the Half-Year Convention for Years 1 & 6:

MACRS Annual Percentages

    • Year 1: 20%
    • Year 2: 32%
    • Year 3: 19.2%
    • Year 4: 11.52%
    • Year 5: 11.52%
    • Year 6: 5.76%

 

Accelerated Method (MACRS) Deductions

    • Year 1: $100
    • Year 2: $160
    • Year 3: $96 (but since the Straight-Line Method is $100, $100 would be your Deduction)
    • Year 4: $58 (but since the Straight-Line Method is $100, $100 would be your Deduction)
    • Year 5: $58 (but since there is only $40 left, $40 would be your Deduction)
    • Year 6: $28 (since there is no balance left, $0 would be your Deduction)

 

As you can see, using the Accelerated Method gives you a bigger Deduction in the first two years, equal Deductions in the next two, and relatively small Deductions in the last two years, compared to using the Straight-Line Method.

There is also one other Method of Depreciation that I would like to discuss. It is the Section 179 Expense Deduction. It is a one-time use Method for each Asset.

 

Section 179 Expense Deduction

 

This Deduction allows you to deduct the entire Cost (subject to certain limitations) of an Asset in the year you acquire and start using it for business. You can apply this Deduction, regardless of the Method of Depreciation that you choose to use.

Here are the rules and limitations:

    • The Asset must be tangible personal property, including software (not real estate).
    • It must be used in a trade or business (property used in a rental activity is generally not eligible).
    • You must take the Deduction in the year you start using the Asset.
    • The decision to use Section 179 must be made in the year the Asset is put to use for business.
    • The Deduction can not be more than your Earned Income (net business Income and Wages) for the year.

 

Any Section 179 Deduction that is not used in the current year because it is greater than your business Income can be carried over to subsequent years.

You can use the Section 179 Deduction anytime it seems to make sense to you, bearing in mind, that while you are benefiting greatly now, it may cost you more in the future by reducing your Deductions and possibly putting you into a higher Tax Bracket.

 

Conclusions

 

There are several Methods of Calculating Depreciation that can be used. They include:

  • Straight-Line Depreciation:  This Method is simple and straightforward, but immediate gratification is limited. Your largest Deductions will come in later years. New businesses that are just starting out and expect to be much more profitable in later years often choose this Method, deferring the greatest Deductions to a later time.

 

  • Accelerated Depreciation:  The bulk of Depreciation takes place in earlier years, with the Deductions in later years much smaller.

 

  • Section 179 Expense Deduction:  This allows you to take a Deduction for the entire value of the property or Asset in the 1st year. It’s capped at $500,000. If the Deduction is greater than your Income, you can carry the balance of the value over to later Tax Years.

 

Although you may use different Methods of Depreciation for different Assets, it is my recommendation to choose a Method, use it for all of your Assets, and continue using that same Method, each year that you are in business. This will make your Bookkeeping much easier.

If you choose the Straight-Line Method to depreciate an Asset, you can not switch to MACRS later. However, you may use a different Method for other Assets.

Choosing the Accelerated Method allows you to switch to the Straight-Line Method for the years when the Deduction amount for a given Asset is equal to or more than the Deduction when using the Accelerated Method. The Accelerated Method allows you take the biggest Deductions in the first years that you are in business. Assuming that you will earn more Income as your business grows, this may not be prudent, as you may wind up paying higher Taxes due to fewer Deductions at a later time, and may eventually cause you to be placed in a higher Tax Bracket. You may want to use the Straight-Line Method, which will give you the best long-term Tax benefit.

 

Ultimately, the choice is yours. For myself, although I have used the Accelerated Method in the past for other businesses that I have owned, for my current Online Affiliate Marketing Business, I have chosen to use the Straight-Line Method, along with a few Section 179 Deductions when I feel that it is appropriate. It seems to make the most sense to me, but as I said before, the choice is yours.

 

If you are unsure which Method seems to be your best choice, try comparing your Deductions using each Method for a few of your higher priced Assets. Complete the Depreciation Deductions for all applicable years and compare the two. Choose the Method that you believe best suits your needs.

 

Please leave a Comment or ask a Question in the Comments section below.

 

Now, continue on to my Post:  Fixed Assets & Depreciation Spreadsheet – Phase 2 – Step 9.

 

Thank you,

CJ Dodaro

 

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About Author

CJ Dodaro
I am a semi-retired, 65 year young man who has owned and operated a variety of successful business throughout my life. Starting most from scratch, I have acquired extensive knowledge for what is required for setting up a business properly from the ground up. Since these businesses have been both the brick & mortar type as well as the online variety, I feel qualified to help people in almost any business area that they wish to pursue. I wish to share the information that I have acquired in order to help other aspiring entrepreneurs become successful.

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