Depreciation is the loss of value over time for a physical item purchased for a business. The Internal Revenue Service (IRS) allows deductions for depreciation so that business owners can recover expenditures they made for the purpose of earning income.
Medical Equipment Useful Life
The IRS classifies items, called fixed assets, and assumes a period of useful life. Office furniture, for example, including desks, chairs, lamps and literature racks, are assumed to have a useful life of seven years. Computers and medical equipment are assumed to have a useful life of five years.
The Straight-Line Method
The straight-line method is preferred by many taxpayers to calculate depreciation because it is easy to calculate. Each year is the same over the useful life of an asset. Here is the formula for straight-line depreciation:
Straight Line Basis = (Purchase Price of Asset - Salvage Value) / Estimated Useful Life of the Asset
For example, say you purchased a piece of medical equipment for $10,000. The IRS allows for a five-year useful life of the equipment. After five years, the equipment has a salvage value of $500.
The straight-line basis equals $1,900 [(10,000 - $500)/5 years]. You can deduct $1,900 per year for the five-year useful life period, until $500 is left on the books as the value of the item.
IRS Section 179 Deductions
IRS Section 179 allows for some flexibility in taking deductions for depreciation, including depreciation on medical equipment. Suppose you have record earnings in the year you purchase the equipment. Suppose, too, that by significantly lowering your tax bill, you could purchase more equipment or hire more people. The IRS allows you to deduct the full cost of the purchase price of an asset in the first year. Doing so, however, means that there will be no deductions for depreciation of the asset in subsequent years.
Modified Accelerated Cost Recovery System
The Modified Accelerated Cost Recovery System (MACRS) allows you to take a bigger deduction for depreciation on medical equipment for the early years in the life of an asset. Table A-1 in IRS Publication 946 shows depreciation percentages allowed under MACRS for assets with a useful life of three, five, seven, 10, 15 and 20 years. The IRS uses the half-year convention for these assets, meaning that, no matter when the asset was put into service, it is assumed that the in-service date is mid-year. This assumption effectively provides an additional year of the depreciation deduction.
Medical equipment's useful life is assessed at five years. The MACRS schedule for depreciation on that medical equipment is as follows:
- Year 1 (second half of the year): 20%
- Year 2: 32%
- Year 3: 19.20%
- Year 4: 11.52%
- Year 5: 11.52%
- Year 6 (first half of the year): 5.76%
For example, an asset costing $120,000 with a salvage value of $20,000 would see a depreciation of $100,000 over the depreciation period, as follows:
- Year 1: $20,000 deduction
- Year 2: $32,000 deduction
- Year 3: $19,200 deduction
- Year 4: $11,520 deduction
- Year 5: $11,520 deduction
- Year 6: $5,760 deduction
After 6 years, $100,000 of the purchase price of the equipment is recovered.
The Right Depreciation Method for Your Business
Depreciation allows you to reduce the amount of taxes owed in a year or over a period of years. Consider whether it is better to offset earnings in one year or over the useful life of an asset. Each of the depreciation methods described has both advantages and disadvantages. A new business, for example, might benefit from higher deductions in the beginning when earnings aren't as high. An established business might employ the straight-line method to simplify calculations.