I have a small business on the side that started out as a hobby (playing music). When I started making money at it, I deducted expenses like guitar strings, mileage to gigs, etc.
Last year, I bought some pretty expensive guitars, and would like to deduct them. As I understand it, for durable items, you divide the price by some number of years, and deduct that fraction each year. You also have to account for any profit over the depreciated value if you sell the item.
Could someone summarize this for me, or point me somewhere where I could learn more? Thanks.
[Not a Tax Professional]
An obvious place to start is, of course, the IRS. In my limited experience, their explanations are fairly straightforward. You might want to start with Publication 946 (2003), How To Depreciate Property and work from there. Also check out the instructions for form 4562, Depreciation and Amortization. As for a summary, someone else can give that a shot.
[/NATP]
You’ve got the basics. If the property will last more than a year, then you depreciate as you said over its useful life. Most equipment gets depreciated over 3-7 years. Dividing evenly is “straight line” which you can always do, and there are ways to “accelerate” or take more of your depreciation in the ealier years. Not sure off-hand exactly when you can do that.
As for sales, you start with your purchase price called “basis.” As you take depreciation deductions you lower the basis by that amount. (At the end of the useful life, your basis is zero.) Upon sale, the difference between the price you get and your basis at that point is either a gain or a loss (depending on whether what you get is higher or lower than your basis).
The relevant Internal Revenue Code sections are 167 and 168, and the regulations beginning at 1.167 are helpful and are in somewhat plain English.
IRS.gov will have more info, and I’m thinking if you google the section numbers and the topic, some CPA firm will have some of the basics summarized on their site.
As you would expect, the IRS will generally be happy if you depreciate slowly and report all gains, and would have a problem with you if you were deducting large amounts for capital goods all in year 1.
I’m not sure about the rules for small businesses, but I can summarize how corporations treat depreciation.
First off, the depreciation example that you gave is an example of straight-line depreciation (in which you depreciate the same amount each year for the life of the asset). There are other, more-accelerated versions that companies use for accounting purposes. Companies are allowed flexibility for their accounting statements. But depreciation for taxes is a whole different animal. Companies must use the appropriate depreciation based on the type of asset. The IRS occasionally audits that they’re using the correct method. Thus, corporations maintain 2 sets of books, one for accounting statements and one for paying taxes. Some companies maintain other “internal” books, as Enron and Worldcom did, but I digress…
If you’re making a profit, it’s generally in your best interest to take depreciation as quickly as possible. This is because depreciation is a non-cash expense. This means that you can deduct it from profit, reducing your taxes to be paid, without incurring any cash costs. But if you plan on selling the asset, the gain on the sale will be the amount above the depreciated value. Taxes must be paid on this gain. In this case, it may be better to use a slower depreciation schedule. I’m not certain that a small business has any flexibility here.
I’m not sure how much detail you need. It’s impossible to know everything, but it seems you’ve got the essentials. People do this kind of work as a career and even they don’t know all of it.
Assuming you don’t have a large business, you can probably deduct the entire amount in the first year without the hassle of depreciation. Section 197 of the Internal Revenue Code allows for an “election to expese certain depreciable assets.”
You can’t take this deduction for more than $100,000 worth of purchases in a single year between 2002 and 2006. You also cannot take the deduction in excess of your income from the business.
This is the provision that allowed certain people to deduct a Hummer in the past few years. It was intended for businesses such as yours. No IRS agent really wants to spend his time examining your depreciation schedules. That time is better spent looking for bigger fish to fry.