The assets that are a part of your business have a significant impact on your taxes. Depending on whether the type of asset is ‘tangible’ or ‘intangible’ , there are different ways to account for the “use” of your assets, often referred to as amortization and depreciation.
Amortization and depreciation are very similar in that they spread out the cost of an asset over time. Amortization is applied to intangible assets where depreciation deals with tangible assets used in the business. This is a key distinction between financials for accounting purposes and for tax purposes, so it is important for every business owner to understand. We discuss amortization vs. depreciation below.
What Is Amortization?
If you have ever obtained a mortgage or auto loan, then you are probably familiar with amortization. Amortization applies to intangible assets such as business licenses, patents, interest associated with loans, and certain lease or licensing agreements.
Loans that are amortized can vary in term length; for example, mortgages are available in 30-year, 15-year, and even 10-year terms. With an amortized loan, most of the initial payments are applied to the interest portion of the loan. However, at some point the scale tips, and a larger portion of the payment is applied to the balance of the loan, eventually paying off the debt. This is something that isn’t always broken down well in statements from your bank, however, an amortization table can break out principal versus interest.
How Amortization Applies To Your Accounting
As most of our clients know, the principal cannot be deducted for tax purposes (this is covered in depreciation below), but amortized interest can be. If you have a rental property, this means that you need to remove the full mortgage payment from your income statement and reflect the interest only. You can do this by creating an amortization schedule showing how interest is paid over time (see table below).
The schedule below shows monthly payments – how much of each payment is principal vs. interest, as well as how those amounts are accumulated over time for a $220,000 ten-year loan at a 7.0% interest rate. One important observation is, as described in the section above, that at the beginning of the loan, a large amount of the payment goes toward interest payments. From a tax perspective, it’s also important to note that while the taxpayer may be out of pocket $30,653 in payments, the tax return will only reflect a $14,901 deduction – something that should also be reconciled in a Company’s or business owner’s accounting system.
Also important is that the financial metric of EBITDA (earnings before income taxes, depreciation and amortization), which is a favorite of investors (both on Main Street and Wall Street), and excludes amortization and depreciation in order to gauge expenses before these accounting adjustments are applied.
What Is Depreciation?
Various other types of transactions must be amortized from an accounting and tax perspective. While taxpayers looking to maximize deductions, may prefer not to spread out their expenses over useful life (the length of time the asset will be in service), note that it is required according to the Internal Revenue Code, as well as under established accounting practices (GAAP and IFRS).
These transactions include:
- Purchase of websites,
- Acquisition of a business license,
- Purchase of a business name or trademark,
- Purchase of a process / method used in the business.
Often, accountants will look at how large or frequent intangible transactions are in order to gauge materiality. Any discussions about specific transactions should be discussed with your advisory team.
Certain business licenses can be quite costly depending on the type of license and the location of your business. If you purchase a license for $50,000 and it is good for 10 years, it is likely that you will need to amortize the expense over its term or useful life. In this instance, your annual deduction comes out to $5,000 per year when you divide the total purchase price by the number of years outstanding. You would also need to adjust for the purchase data in the first year (so if it was purchased in June, you would get approximately half of the first-year deduction). This allows you to spread out the tax benefits instead of taking them all up front. The goal of amortization is to closer align the expense with the income the asset will produce over time.
What Is Depreciation?
Depreciation is very similar to amortization when it comes to your accounting, however it is applied to your tangible assets. For example, if you purchase a new work vehicle, you can depreciate the vehicle over its useful life. If the cost of your vehicle was $30,000 and its useful life is 5 years, you can depreciate $6,000 per year. Again, the goal of depreciation is to match up the expense with the income that helps to facilitate that expense.
How To Calculate Depreciation
The easiest way to calculate depreciation is with the straight line method. To calculate depreciation using the straight line method, you will need to know the original cost of your asset, as well as the salvage value (the value it retains at the end of its useful life), and useful life. For vehicles, the useful life is usually around 5 years. Another method that can be used to calculate depreciation is the declining balance method, where the majority of the assets’ depreciation is recognized early on in its useful life and decreases in years 3 and on.
There are different types of depreciation for different assets. The IRS has largely given guidance on useful life via the modified accelerated cost recovery system (MACRS). The MACRS table references asset classes and the appropriate time frame to depreciate that asset. An example table can be seen below.
Amortization vs. Depreciation
When considering amortization vs. depreciation the key similarities are that both spread out the cost of the asset over its useful life and aim to match up the expense of the asset with the income it helps earn. However the difference is that amortization applies to intangible assets, while depreciation applies to tangible assets, because of this, different methods of calculation can be used. Amortization almost always utilizes the straight line accounting method, while depreciation may use either the straight line or accelerated method. It is also important to note that with amortization, there is no salvage value like there is with depreciation.
Get Help With Your Deductions
When determining the best strategy for your deductions, it is best to work with a tax advisor. Amortization and depreciation can be confusing for many taxpayers, we want to make sure you get the most out of your deductions to help you save on taxes and plan for your future. To learn more, sign up for our newsletter or connect with one of our strategy advisors.