Most non-accountants roll their eyes and shudder when the topic of “depreciation” comes up. I suspect this is also true for some RTO business owners and managers. To many people, depreciation seems far too complicated to try and figure out. But is it really? Read the following definition of depreciation and see for yourself:

Depreciation defined
Depreciation is defined as a portion of the cost that reflects the use of a fixed asset during an accounting period. A fixed asset is an item that has a useful life of over one year. An accounting period is usually a month, quarter, six months or one year. Let’s say you bought a Big Screen TV for your rental equipment on January 1, for $1000 and it was determined that the Big Screen TV had a useful life of two years. Using a one month accounting period and the “straight-line” method of depreciation, the portion of the cost to be depreciated would be one-twenty-fourth of $1000, or $41.67 per month.

Seems pretty straightforward. If you look closely, you will see that there are only five pieces of information you must have in order to determine the amount of depreciation you can deduct in one year. They are:

The nature of the item purchased (the TV).
The date the item was placed in service (January 1)
The cost of the item ($1000).
The useful life of the item (two years).
The method of depreciation to be used (straight-line)

The first three are easy to figure out, the second two are also easy but require a little research. How do you determine the useful life of an item? Let me regress for a moment. There is “book depreciation” which is based on the real useful life of an item, and there is the IRS version of what constitutes the useful life of an item. A business that is concerned with accurately allocating its costs so that it can get a true picture of net profit will use book depreciation on its financial statements.

The IRS Method
However, for tax purposes the business is required to use the IRS method. The IRS may have shorter or longer useful lives for fixed assets causing a higher or lower depreciation write-off. The higher the write-off, the less tax a business pays. The long and short of it is that you end up having to create a book financial statement and a tax financial statement. So, most small businesses that aren’t concerned with a precise measurement of their net profit use the IRS method on their books. This means that all you have to do is look in IRS Publication 946 (Rev. 2002 .pdf ) to find the useful life of a particular item.

Most RTO businesses that take the time to record book depreciation for their rental equipment, use eighteen months to two years as a useful life. Useful life for rental equipment is an important factor in determining whether the net profit of a business is higher or lower because rental equipment depreciation is a direct cost against rental revenue. Knowing when to match depreciation expense against revenue generated from renting equipment can be a challenge for those RTO businesses concerned about financial statement accuracy.

3 Year MACRS...just for us!
For tax purposes, the IRS gives special consideration to RTO businesses by allowing a three-year useful life for rental equipment. However, regardless of the depreciation method you use internally for your business whether it is straight-line, double-declining, units-of-production, income forecasting or any other method, you are required to use MACRS straight-line or double-declining methods when doing your taxes. All other non-rental fixed assets must be depreciated using the designated standard cost-recovery periods under MACRS.

So many methods...so little time
The last piece of information you need is found by determining the method of depreciation to use. Most often it will be one of two methods: the “straight-line” method, or, an accelerated method called the “double-declining balance” method. Let’s briefly discuss these two methods:

Straight-line:
This is the simple method mentioned in the definition above. Just take the cost of the item, divide it by the useful life and you’ve got the answer. Yes, you will have to adjust the depreciation for the first year you place the item in service and for the last year when you remove the item from service. For instance, if your depreciation for one year was $150 and you placed the item in service on April 1 then divide $150 by 12 (months) and multiply $12.50 by 9 (months) to get $112.50. If you removed the item on February 28 then your deduction will only be $25.00 (2 x $12.50).

Double-declining balance:
The idea behind this method is that when an item is purchased new, you will use up more of it in the earlier years of its life, therefore, justifying a higher depreciation deduction in the earlier years. With this method, simply divide the cost of the item by the useful life years as in the straight-line method. Then, multiply that result by 2 (double) in the first year. The second year, take the cost of the item and subtract the accumulated depreciation. Next, divide that result by the useful life and multiply that result by 2, and so on for each remaining year.

Most RTO businesses will use the “straight-line” method for their rental equipment. But, either way, you don’t have to run a calculation because the IRS provides tables (Pub 946) that have the percentages worked out for each year of the two different methods. Not only that, they have set up a special first year “convention” that assumes you purchased your depreciable fixed assets on June 30. This is called the one-half year convention. The idea behind this is that you may have bought some items earlier than June 30 and some after that date. So, to make it easy to figure out, they assume the higher and lower depreciation amounts will all average out.

Actually, the IRS doesn’t even call it depreciation anymore; it is now called “cost recovery”. Before December 31, 1986 we had ACRS (pronounced “acres”) or Accelerated Cost Recovery System. Currently, we have MACRS (pronounced “makers”) or Modified Accelerated Cost Recovery System.
Understanding how basic depreciation works can be valuable to you as a small business owner because it helps to know the tax implications when planning for capital equipment purchases.

My next article will focus how you can depreciate up to $24,000 in one year if you meet the qualifications. In addition, I will discuss the new 30% bonus depreciation that congress made available last year.