Depreciation is the most complicated tax issue family child care providers face.
It’s complicated because there are so many rules associated with it and they often change from year to year. And there’s a lot of math involved! What fun.
What is depreciation?
Depreciation is the process of spreading the deduction of an item over a number of years, rather than deducting it in one year.
You must depreciate any item you purchase costing $2,500 or more that you use in your business. You are also entitled to depreciate any item you owned before you went into business that you start using for your business.
Here’s a basic example of how depreciation works.
Let’s say you bought a $3,000 refrigerator.
1) How much of the refrigerator can you depreciate?
Since you are using it in your business, you can deduct it. Since it costs more than $2,500 you must depreciate it. Since it’s used by your family and your business, you can’t depreciate the entire cost.
Therefore, you will use your Time-Space Percentage to determine the business portion of the refrigerator you can depreciate. Let’s say your Time-Space Percentage is 40%.
$3,000 x 40% = $1,200. This is the business portion of your refrigerator.
2) How long do you depreciate the refrigerator?
All items costing more than $2,500 fall into one of these depreciation categories: office equipment (5 years), personal property (7 years), land improvement (15 years), home improvement (39 years), home (39 years) or car (5 years). For more information, see my article: “The Categories of Depreciation.”
The refrigerator is considered “personal property” so it must be depreciated over 7 years. The phrase “personal property” here can be confusing. Essentially it means any property that’s not attached to your home or land and is not office equipment. It doesn’t mean property that is only personal. So, if you bought a $2,900 children’s furniture set, it would be depreciated over 7 years as well.
3) How much is claimed as a depreciation deduction in the first year?
Now it gets more complicated. There are two ways you can depreciate seven year property. You can use the straight line method of depreciation or an accelerated method of depreciation.
The straight line method would give you approximately the same amount of depreciation deductions each year. You would claim 7.14% the first year; 14.29% for years 2-5; and 7.14% for year eight.
You might now say, “What is going on? Why are we depreciating the refrigerator over eight years? I thought were were using the seven year depreciation rule.”
There is another rule that says you can’t claim a full year’s depreciation deduction in the first year, because you may have purchased the item in the middle of the year. Therefore, you only get a half a year’s depreciation in the first year (no matter when you purchased it) and the other half at the end, or year eight. Aren’t you glad you asked?
The accelerated method would give you higher depreciation deductions in the first few years and lower deductions in the later years. You would claim 14.29% in the first year; followed by 24.49%; 17.49%; 12.49%; 8.93%; 8.92%; 8.93%; and 4.46%.
Yes, this is also spread over eight years for the same reason as described above.
Which method should you use?
Because the accelerated method gives you deductions faster, it’s almost always better to use this method. A deduction this year is worth more to you than a deduction next year, because you can use the money now or invest it.
So, using the accelerated method:
$3,000 x 40% = $1,200 x 14.29% = $171.48 first year depreciation deduction.
4) Where is my depreciation deduction claimed?
IRS Form 4562. In this case, seven year property is claimed on line 19c.
If you use personal property (or office equipment) more than 50% for your business, you can use the Section 179 rule and deduct the business portion all in one year, rather than depreciating it. So, for example, if our refrigerator was used 55% for the business, we could deduct $1,650 ($3,000 x 55% = $1,650) in the first year on IRS Form 4562, Part I. See my article, “The Section 179 Rule: A Powerful Way to Cut Your Taxes.”
Also – Congress has passed a bonus depreciation rule that allows providers to deduct an additional amount of depreciation in the first year. This bonus depreciation rule has been in flux, so check with my annual Family Child Care Tax Workbook and Organizer for the latest details.
To use a business percentage other than your Time-Space Percentage for items used for both business and personal purposes, you must keep several months of records that show the actual business use. See my article, “How to Calculate an Actual Business Use Percent.”
Is it worth it?
Some tax professionals tell providers that it’s not worth depreciating a refrigerator to get only a $171 deduction the first year. This is bad advice. Over the course of eight years you will get a $1,200 deduction! Also, even a $171 deduction will reduce your taxes in the first year, so why not get it? It’s your money. Lastly, you may have purchased other items besides a refrigerator and therefore your depreciation deduction will be higher.
My annual book Family Child Care Tax Workbook and Organizer has a long chapter explaining all of the depreciation rules in detail. It shows you how to calculate your depreciation deduction and where to put it on your tax forms.
If you use a tax preparer, let that person look at your receipt for the refrigerator and calculate your depreciation deduction.
Note for KidKare users
This software allows you to label and track items you purchase that cost more than $2,500. Although it won’t calculate your depreciation deduction, it will organize these expenses so your tax professional (or you) may more easily fill out your tax forms.
Tom Copeland – www.tomcopelandblog.com
Image credit: www.allyou.com
For more, see my 2016 Family Child Care Tax Workbook and Organizer.