finance
Depreciation
Spreading the cost of a long-lived asset across its useful life as an expense.
Definition
Depreciation is the accounting practice of allocating the cost of a long-lived asset (equipment, vehicles, computers, buildings) across its useful life. Buy a $30K vehicle with a 5-year life, depreciate $6K per year. Depreciation is a non-cash expense - the cash already left when you bought the asset, depreciation just spreads the cost over time on the P&L. This is why EBITDA (which adds depreciation back) is often used to measure underlying cash generation. For tax, depreciation rules differ from accounting - work with your CPA to maximize the tax benefit.
Book versus tax depreciation in the US
US businesses keep two sets of depreciation schedules: book (GAAP for financial reporting) and tax (IRS rules for tax filing). Book depreciation usually uses straight-line over the asset's useful life (e.g., 5 years for a vehicle, 7 for office furniture, 39 for commercial real estate). Tax depreciation uses MACRS (Modified Accelerated Cost Recovery System), which front-loads deductions to lower current tax. The gap between book and tax depreciation creates deferred tax assets or liabilities on the balance sheet. For US small businesses on cash-basis accounting, the distinction is minimal; for accrual-basis businesses, your CPA tracks both. Section 179 and bonus depreciation can dramatically accelerate tax deductions, sometimes letting you expense 100 percent of qualifying assets in the year purchased.
Section 179 and bonus depreciation
Two major US tax provisions accelerate depreciation deductions. Section 179: lets US businesses expense up to 1.16M (2024 limit, indexed annually) of qualifying equipment, vehicles, off-the-shelf software, and certain real property improvements in the year of purchase rather than depreciating over years. Phases out for businesses spending more than 2.89M on Section 179 property. Bonus depreciation: under the Tax Cuts and Jobs Act, 100 percent bonus depreciation phased down to 60 percent in 2024, 40 percent in 2025, 20 percent in 2026, with full expiration unless Congress extends. Strategic timing: large equipment purchases late in a profitable year, claimed via Section 179 or bonus depreciation, can materially reduce current tax bill. Coordinate with your CPA before year-end.
Common assets and their US depreciation lives
Standard MACRS class lives for common US business assets: computers and peripherals, 5 years; office furniture and fixtures, 7 years; vehicles (passenger autos), 5 years with annual luxury auto limits; office equipment, 7 years; light trucks and SUVs over 6000 pounds, 5 years (qualifies for Section 179 with limits); commercial real estate, 39 years; residential rental property, 27.5 years; land improvements, 15 years; qualified improvement property, 15 years and bonus-depreciation eligible. Software has special rules: off-the-shelf software, 36 months straight-line; internally developed software, 60 months. Each class has specific IRS rules; Pub 946 is the reference.
Depreciation impact on cash, P&L, and valuation
Depreciation is non-cash but real. The cash left when you bought the asset; depreciation just allocates that historical cost to future periods. P&L impact: depreciation reduces reported net profit and therefore reduces taxable income, which reduces actual cash taxes. Valuation impact: depreciation is added back to compute EBITDA, the standard metric for valuing businesses with capital assets. Two businesses with identical operating cash flow can show different net profit purely from depreciation choices; EBITDA normalizes. When evaluating capital expenditures, use cash flow analysis (NPV, payback period) - not just depreciation impact - because timing of cash matters more than timing of expense recognition.
FAQ
Is depreciation a cash expense?
No. Depreciation is purely an accounting allocation of cash that was spent in a prior period (when the asset was purchased). The cash flow statement adds depreciation back to net profit when computing operating cash flow, precisely because no cash leaves the business as depreciation accrues. The actual cash outflow happens when you write the check to buy the asset. This distinction matters for cash flow forecasting, where you must look at capital expenditure schedules (not just depreciation expense) to predict actual cash needs.
Should I take Section 179 every year?
Not automatically. Section 179 reduces current-year taxable income but eliminates future depreciation deductions. If you expect higher tax brackets in future years (growing business with rising profits), spreading depreciation across years may be more tax-efficient than accelerating it now. If you expect flat or lower future taxes, accelerating with Section 179 is generally better. Run the analysis with your CPA before each year-end. The choice is permanent for the assets selected.
How does depreciation work when I sell a depreciated asset?
When you sell a US business asset, the difference between sale price and remaining book value (cost minus accumulated depreciation) is gain or loss. If the asset was depreciated below its sale value, the depreciation 'recaptured' is taxed as ordinary income (up to the accumulated depreciation amount), not capital gains. This is called depreciation recapture under IRC Section 1245. For real estate, the recapture rate is capped at 25 percent under Section 1250. Plan asset sales with your CPA; the tax consequence can be material on equipment sold for more than book value.
Can I depreciate software?
Yes, with rules. Off-the-shelf software purchased separately depreciates over 36 months straight-line and qualifies for Section 179. Custom-developed software amortizes over 60 months. SaaS subscriptions are operating expenses, not depreciable assets - they hit the P&L immediately. The shift from on-premise software (CapEx, depreciated) to cloud software (OpEx, immediate expense) is one reason US business depreciation expense has declined as a percentage of revenue over the past decade.
Does depreciation affect my business valuation?
Indirectly. EBITDA-based valuations add depreciation back, so depreciation per se does not reduce valuation. However, businesses with high ongoing CapEx requirements (to maintain depreciable assets) are valued lower than asset-light businesses with similar EBITDA because the cash flow available to owners is lower after maintenance CapEx. Investors and acquirers look at maintenance CapEx versus growth CapEx separately. A trucking business with 500K annual EBITDA but 300K maintenance CapEx is worth less than a software business with 500K EBITDA and 30K maintenance CapEx, despite identical headline profitability.
In your business
- →Track book depreciation (accounting) and tax depreciation separately - they differ
- →Section 179 in the US lets you expense some assets immediately rather than depreciate - check eligibility
- →When evaluating asset purchases, use cash impact - not just depreciation expense