Maximizing Your Tax Obligation - Part II - Depreciation

Depreciation Expense

While some business expenses are rather obvious and simple, there is one expense that is complicated and is not easily understandable for non-accountants. This rather complicated expense is Depreciation Expense.

Depreciation is an accounting terms and has to do with tax treatment for large purchases that have a useful life beyond one year.

While some expenses are temporary and have a very short life (office supplies, advertising, bank charges, etc.), depreciation is how you properly account for the purchase of long-term capital assets.

In the photography business, cameras and lenses fall into this category. If you do not take an auto expense based on miles driven at the going IRS guideline rate (see Part I of this series), your vehicle would fall into the capital asset category.

You can also add purchases that will be useful beyond the year it was purchased and was bought for a significant amount of money into the category. Equipment like tripods, lighting systems, expensive backpacks, and other substantial items are also included.

Example -

If your business took in $6,000 of income (billings) for the year and you purchased a camera that cost you $5,000, the end result will NOT be a profit of $1,000.

The tax laws dictate that items, such as your $5,000 camera, must be depreciated rather than being considered a $5,000 business expense.

The logic adopted by the IRS and AICPA (an organization of CPA’s) is that your camera will be useful well beyond the year it was purchased and therefore you get to recover its total cost over the useful life of the equipment. Cameras generally have a recovery period of 5 years.

This means that you get a depreciation expense of $1,000 a year for that camera. However, unless you purchased the camera on January 1st you will need to prorate the deprecation expense according to its purchase date. For example, if you purchased the camera on April 1st you would get $750 of depreciation expense for your initial year ($1,000 x 9 months/12 months= $750). If you purchased the camera on October 1st you would get a $250 deduction ($1,000 x 3 months/12 months=$250).

The IRS does give you the option of either depreciating an asset based on your month of purchase, or you can take every asset purchase and take 6 months of depreciation in all cases. You must be consistent and cannot choose actual date of purchase for one item and 6 months of depreciation for another. I like to take a consistent 6 months so that I can make a purchase near the end of the year if I know I need some write-offs and get a meaningful deduction rather than just 1 month.

If you bought this camera in 2022, you would get a $500 deduction for that year, $1,000 for 2023, 2024, 2025, 2026 and $500 for 2027. At this point you would have gotten a total of $5,000 in depreciation for that $5,000 camera purchase. In 2027 and later you would not be eligible for a depreciation expense of that camera because you would have recovered the entire purchase price.

You also may have to allocate an amount of the total cost for personal use. If you bought that $5,000 camera, but you use it for personal or family photos 20% of the time (pick a percentage that you can justify) instead of getting a $500 deduction in year one, $1,000 in the next 4 years and then $500 in 2027, you would get $400, $800 for 4 years and then $400. That $5,000 purchase could only have a business expense for depreciation based on $4,000 ($5,000 x 80% business use).

Other purchases like lenses, tripods, lighting equipment, etc. would follow the exact same rules, although their useful lives may be different.

Since the photography business deals with a lot of purchases of equipment, and also the sale of used equipment when you upgrade to a newer model of camera or lens, there is another wrinkle in dealing with these capital assets.

Each capital item has a “book value” that is the original purchase price less the depreciation taken on it. So our $5,000 camera sold at the end of its second year would have a book value of $3,500. That would be the initial half year of depreciation (if you adopted the half year of depreciation in the initial year of purchase) plus a full year. That gives the camera a “book value” of $3,500.

If you were to sell that camera to a used camera equipment company, or sell it yourself on ebay, the amount of money you received for the sale would need to be compared to the book value to see if you had a gain or a loss on the sale of the asset. If you sold it for $4,000 you would have a gain of $500 ($4,000 - $3,500), if you sold it for $3,000 you would have a loss of $500. You will need to claim either the gain (as income) or the loss (as an expense) on your tax return.

The logic is that if you sold it for more than book value, you actually took more depreciation than you should have, if you sold if for less than book value then you rightfully should have taken more depreciation than you actually took.

There are other rules for depreciation that a tax preparer should be aware of, including the ability to take an accelerated amount of depreciation expense in the year of purchase. They will also advise you on the method of depreciation. In our example we used the straight line method where we divided by the useful life of the camera. There are other methods such as double-declining balance, declining balance, etc. where you can take a higher amount of depreciation early in the life of the camera. However there is no free ride. On these methods that allow for a larger depreciation expense early in the camera’s life, there will be lesser amounts after that. No matter what, you can only take a total depreciation during the life of your camera that is equal to its $5,000 purchase price or lower if you have some non-business usage. They will get you now, or they will get you later.

You should always consult with a tax consultant for matters concerning items in this blog for accuracy.