By Manny DaRosa, CPA
Many business owners and accountants talk yearly about depreciation and how they can save on their tax bill by purchasing new equipment. But what does depreciation actually mean?
Depreciation provides the means of deducting the cost of a capital asset over a specified recovery period. Depreciation has various definitions for tax and financial purposes. Under current tax laws, you can purchase equipment and deduct the full purchase in the current year on your tax return. If you use this depreciation method, you will feel that your equipment is worthless at the end of the year. The benefits of tax deductions should never be the only reason to buy equipment.
The best method for managing equipment depreciation is to keep a simple list of equipment by year and estimating how long the equipment remains useful. For each piece of equipment, you track purchase price and subtract the depreciation amount per year until the equipment value hits $0. When that happens, it’s time to consider whether or not to replace it.
Another method is to track the repairs and maintenance (R/M) of each piece of equipment. The R/M account is one of the most important expense items and needs constant analytical review. Once R/M expenses start running more than the yearly depreciation, a decision to replace should be reviewed.
When the analysis states you need to buy equipment, you then need to evaluate the financial aspects. I often counsel clients who will finance the purchase to take a loan term that is at least one year less than the expected life of the asset. If you need to replace the equipment a year or two before the loan is paid off, disposing of the equipment and paying off the loan may prove difficult.
The equipment decision obviously includes whether to buy or lease. Purchasing is almost always the least expensive method versus lease arrangements. However, many equipment manufacturers offer attractive lease financing and buyouts. These types of arrangements (i.e., 0% financing and $1 buyout) are actually considered a purchase, and the equipment can then be depreciated for tax purposes. Always avoid a lease with a fair market value or designated purchase amount at the end of the lease.
When preparing your equipment budget, try to reserve cash that would amount to about 10% to 20% of the yearly equipment purchase. That cash in reserve will allow you to make a down payment when financing. Many banks will only loan 80% to 90% of the equipment purchase.
Although the benefit of tax deductions should never be the decisive factor in purchasing equipment, the method of disposing old equipment should be. If the equipment has no value and you plan on disposing of it (junking not selling), this would be the preferred method. If there is value in the disposed equipment, it is always best to trade it in for the purchase of a new piece of equipment. For valuable used equipment this would allow you to avoid paying taxes on the trade-in. In the tax world this is called a like-kind exchange.
The ability to mange equipment depreciation in your business will allow you to operate with the lowest overhead cost possible. In such a competitive environment, equipment depreciation management allows you to bring vital dollars to the bottom line, securing funds for your firm to purchase new equipment in the future.
Tax time tips
Reserve 10% to 20% of your yearly equipment purchase budget in a separate account.
Always trade in high-value used equipment to avoid capital gains taxes.
Keep good equipment depreciation and maintenance records, which include estimating yearly depreciation and repairs for each piece of equipment. Evaluate the yearly repairs with the yearly depreciation.
Never use potential tax benefits as a factor in purchasing equipment. If you buy a piece of equipment because your accountant states you get a tax deduction, you still paid out more cash than the tax deduction generated.
Manny DaRosa is a CPA based in Taunton, MA.