Any asset that has a lifespan of more than a year is called a fixed asset. All businesses use equipment, furnishings, and vehicles that last more than a year. Although they may last longer than other assets, even fixed assets eventually get old and need replacing.
Because your business should match its expenses with its revenue, you don’t want to write off the full expense of a fixed asset in one year. After all, you’ll certainly be making use of the asset for more than one year.
You’re probably wondering how you figure out the useful life of a fixed asset. Well, the IRS has done the dirty work for you by creating a chart that spells out the recovery periods allowed for business equipment (see the table below).
| Property Class Recovery Period | Business Equipment |
|---|---|
| 3-year property | Tractor units and horses over two years old |
| 5-year property | Cars, taxis, buses, trucks, computers, office machines (faxes, copiers, calculators, and so on), research equipment, and cattle |
| 7-year property | Office furniture and fixtures |
| 10-year property | Water transportation equipment, single-purpose agricultural or horticultural structures, and fruit- or nut-bearing vines and trees |
| 15-year property | Land improvements, such as shrubbery, fences, roads, and bridges |
| 20-year property | Farm buildings that are not agricultural or horticultural structures |
| 27.5-year property | Residential rental property |
| 39-year property | Nonresidential real estate, including a home office but not including the value of the land |
Recovery periods are the anticipated useful lifespan of a fixed asset. For example, cars have a five-year recovery period because the IRS anticipates that they’ll have a useful lifespan of five years. While the car will probably run longer than that, you’re not likely to continue using that car for business purposes after the first five years. You’re more likely to trade it in and get a new car.
Most accountants use the IRS estimates of useful life unless there’s something unique about the way the business uses its fixed assets, such as a trucking company whose trucks get used up more quickly than those used by a business for occasional deliveries.
In order to calculate depreciation for an asset, you need to know the cost basis of that asset. Here's how you determine cost basis:
Cost of the fixed asset + Sales tax + Shipping and delivery costs + Installation charges + Other costs
= Cost basis
Cost of the fixed asset: What you paid for the equipment, furniture, structure, vehicle, or other asset.
Sales tax: What you were charged in sales tax to buy the fixed asset.
Shipping and delivery: Any shipping or delivery charges you paid to get the fixed asset.
Installation charges: Any charges you paid in order to have the equipment, furniture, or other fixed asset installed on your business’s premises.
Other costs: Any other charges you need to pay to make the fixed asset usable for your business. For example, if you buy a new computer and need to set up certain hardware in order to use that computer for your business, those setup costs can be added as part of the cost basis of the fixed asset (the computer).