Depreciation – What is it?

depreciation

Depreciation and Section 179 Depreciation.

 Depreciation is one of the most confusing concepts you will encounter in business.  I hope to clarify this concept for you.

 Any item you buy, you can depreciate (expense the cost) over time.  The IRS has guideline for this depending on the type of equipment [asset] it is.  Example, if your digital radiography unit costs $15,000 and it falls under the IRS 5 year equipment code, you would write the cost off over 5 years.  Under straight line depreciation it would look like this – $15,000 / 5 years = $3,000 depreciation deduction per year for the next 5 years. There are other versions of depreciation that give you more deductions in the earlier years and less in the later years but the total still comes up to $15,000 over the life of the product.

 Now that is what you get to “write off” on your Profit and Loss as an expense.  This is different from what happens to your checking account.  If you have $15,000 in the checking account and write a check for the whole amount, that transaction doesn’t necessarily hit your expenses on the Profit and Loss;  it is the depreciation expense.  Conversely, you may borrow all the money for the unit and yet the depreciation would stay the same expense on your Profit and Loss (plus the interest you are paying on your loan).

 What I am trying to explain is that your deduction and how you finance the equipment purchase are not connected.  Sounds strange, but it is true.

 Now let’s talk about the Section 179 deduction.  A Section 179 depreciation expense is the Tax Code section that talks about this deduction.  The government, to try to stimulate the economy and entice companies to make capital investments (meaning buying machines and equipment for their business), allows you to take the FULL amount of the expense of the equipment off your taxable profit in the year you bought it up to $560,000 (if I read the latest IRS publication right). So if you buy a piece of equipment, you can deduct the total cost of the equipment this year regardless of whether you pay cash or borrow the money for it.

 Now if you pay cash, then I recommend the 179 deduction because it reflects what is happening to your checking account.  If you borrow the money, I don’t recommend taking the 179 full deduction that year.  Here is why.  First year is great!!!  You get the full deduction and you only make your note payments which are a lot less.  But what about the rest of the years you pay the note???  Here is where you get burned.  You are making those loan payments so cash is going down yet you have no deductions (expect interest) so your profits are higher and you pay higher taxes the rest of the years.  In essences you benefit one year and it hurts you the rest of the life of the asset.  I don’t go for it.

 

 

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