Depreciation and deduction

The Basics of Depreciation

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 $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 $1,000 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 $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%.

$1,000 x 40% = $400. This is the business portion of your refrigerator.

2) How long do you depreciate the refrigerator?

All items costing more than $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 $1,000 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:

$1,000 x 40% = $400 x 14.29% = $57.16 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.

We're done!

Additional information

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 $550 ($1,000 x 55% = $550) in the first year on IRS Form 4562, Part I. See my article, "The Section 179 Rule: A Powerful Way to Cut Your Taxes."

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 $57 deduction the first year. This is bad advice. Over the course of eight years you will get a $400 deduction! Also, even a $57 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 Minute Menu Kids Pro users

This software allows you to label and track items you purchase that cost more than $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.

13 Tax Questions Answered

The April 15th tax deadline is almost upon us. Here are some tax questions I've received from family child care providers recently:

1) Can I deduct my monthly mortgage payment?

-No. You can deduct your mortgage interest on IRS Form 8829 Expenses for Business Use of Your Home, line 10, column b (indirect expense). If your Time-Space Percentage is 35% you would deduct 35% of your mortgage interest on Form 8829 and 65% on Schedule A if you itemize.

You are able to capture the principle payments (that are part of your monthly mortgage payment) when you depreciate your home on Form 8829. See my article "How to Depreciate Your Home." 

2) Can I deduct 100% of my family child care union dues?

-Yes. In some states family child care providers have organized into unions and pay monthly union dues. These expenses can be deducted on IRS Form Schedule C, line 17 Legal and Professional Services. Some child care providers are not a member of a union, but are having "fair share" fees deducted from the payments they receive from the county for caring for children from subsidized families. You cannot deduct these "fair share" fees as a business expense. Instead, you are receiving less income and, as a result, you will pay less in taxes.

3) Can I deduct expenses for lawn maintenance such as a lawn mowing service or landscaping service?

-Yes. Multiply the cost by your Time-Space Percentage.

4) I bought some clothes (t-shirts, gloves, coats) for my day care children. Can I deduct this?

-It depends. If these items are given to the children for them to take home they would be considered "gifts" and are subject to a limitation of $25 per child, per year. There is a difference between a "gift" and an "activity expense." See my article on this. If these items were purchased for the children but kept in your home so they can be used by other children, then there is no $25 gift limitation and the items could be fully deducted as an activity expense.

Image credit: www.pamsclipart.com

5. If the clothes are used for daycare purposes (i.e. extra gloves for when theirs get too wet, t-shirts for extras when they get soiled, extra coats for those cold days when the parents bring them in a spring jacket etc...) wouldn't the clothing then be 100% deductible? 

 Yes, if you kept the clothes. No, if the children took home the clothes for good. I'll rewrite this section to make this point clearer.

6. We are planning on fencing on our entire front lawn, making it a nature exploration area for daycare. Can this entire expense be used as daycare since it will be used for daycare purposes only.

 It would be hard to argue that a fence in a front yard is only used for daycare, unless you have no young children of your own and you never use the front lawn area for personal purposes.

7. Will "fair share" dues be deductible if they are assessed against providers who are not receiving money from the county?
(Can the unions force us to pay these dues?)

Each state has its own rules about how they handle "fair share" payments. If the state makes you pay a "fair share" fee out of your pocket, then it's deductible. But, most states take the "fair share" payment out of the subsidy check before  the provider receives it. In this case, the provider is getting less in payments, reporting less in income and paying less taxes. There is a difference between union dues and "fair share." Unions cannot force providers to join the union or pay union dues. Fair share fees represent the costs associated with the union negotiating with the state to increase payments and provider other services and resources to all providers, those who are union members and those who are not. In most states who set up fair share fees, they are not voluntary.

8. So, for providers who are NOT taking subsidized families, is it your understanding that the union CAN make providers pay them the "fair share"? I'm in MN.

We don't know yet if the union will represent any providers in Minnesota, so I can't answer your question at this time. I don't know what the outcome will be. You can only be charged a fair share if the union is representing you. Whether or not the union will represent providers who do not care for subsidized families is not clear yet.

9. We are an small Day care for 6 children, What Document should we give to the parent to do their taxes? Should we give to them an account statement with the total that they paid for year o every three month?

Give parents an end-of-year receipt that indicates how much they paid you for the year. Give them your Employer Identification Number (EIN) and have them sign one copy that you keep for your files. There is no particular form to use when creating this receipt. You could use IRS Form W-10 and add to it how much the parent paid.

10. How will you do the deduction for a child care provider living in a movable home and paying mortgage for it, and also paying rent for the land? How many years we have to use for the movable house amortization?

You must depreciate the mobile home over 39 years. Deduct the time-space% of the rent on Form 8829.

11. Regarding Mortgage Interest on form 8829, my tax preparer - had entered it on line 16b "Excess mortgage Interest" I told her it should be on line 10b. She said it doesn't make any difference? Is that correct?

It won't make any difference since they are both multiplied by your time-space %. So, don't worry about this.

12. I pay rent where I live, am I able to deduct it with time-space%?

Yes, you can deduct the time-space% of rent, whether you rent a house or apartment.

13. Can I deduct the cost of dental insurance as a "self employed health insurance premium"? According to Turbotax, i can get a credit (as long as I show a profit) for health insurance premiums for me and my family. But, i wasn't sure if dental insurance was included. Turbotax wasn't clear on that.

Tom Copeland - www.tomcopelandblog.com

Claiming expenses for items bought before your bussiness

How Do You Claim Expenses for Items You Bought Before Your Business Began?

By Tom Copeland, posted with permission

There are two different tax rules to apply to items you bought before your family child care business began.

Therefore, we must separate these expenses into two categories.

Items Purchased Specifically For the Business (Start-Up Expenses)

The first category of expenses are those items you bought specifically for the business. They could be a fire extinguisher, toys, supplies, curriculum, advertising, training fees, playground equipment, and so on.

You can deduct up to $5,000 of these expenses in the year your business begins. Start-up expenses are those that individually cost less than $200 or will last less than one year.

* If your start-up expenses exceed $5,000, you must depreciate any amounts above $5,000 over 15 years.

* If you bought an item that cost more than $200 and will last longer than one year, you must depreciate it over 15 years once your business begins.*

For example, let's say you bought ten $50 toys, $450 curriculum, $1,000 in advertising and $100 in training fees between October and December 2013. Your business began on January 1, 2014. You can deduct all of the toys and the training fees because they cost less than $200. You can deduct all of the curriculum and advertising because they are items that you would normally deduct in one year (because they don't last longer than a year).

If you bought a $1,500 playground equipment set in December 2013, you would start depreciating this over 15 years in 2014.

What if You Haven't Depreciated Your Items?

Many providers fail to claim the depreciation they are entitled to. If you did not claim depreciation for household items you owned before you went into business, you can file IRS Form 3115 and recapture all previously unclaimed depreciation on your current tax return. You can also use this form to recapture depreciation on items you bought after you went into business, but didn't depreciate. There is no limit on how far back you can go to recapture this depreciation. See my article "How to Claim Previously Unclaimed Depreciation."

Items Not Purchased Specifically For the Business

The second category of expenses are those items you bought before your business began that were not purchased specifically for your business. They include everything you owned before your business began, then you started using them for your business.

These expenses include: furniture (beds, tables, chairs, sofa), appliances (washer, dryer, freezer, stove, refrigerator, stove, microwave), rugs, lamps, end tables, pots and pans, silverware, television, computer, bedding, pictures on the wall, lawn mower, snow blower, and so on.

These expenses must be depreciated once your business begins. You will depreciate them based on the lower of two numbers: the original price or its fair market value at the time you started using it in your business. In almost every situation this will be the fair market value.

It doesn't matter if the original purchase price or the fair market value was less than $200, or the items were ones that you would normally not depreciate if you purchased them after your business began. Everything must be depreciated.

You can obtain a substantial tax deduction if you conduct an inventory of virtually everything in your home. See my article "Conduct a Household Inventory to Save Money."

For example, let's say you purchased a clock for $25 before your business began and it was not purchased specifically for your business. You would have to depreciate it once your business began. If you bought the same $25 clock after your business began, you would be able to deduct it in one year because it cost less than $200.

Special Circumstances

If you made a home improvement before your business began, add the cost of the home improvement to your house and depreciate it as part of your home. See my article "How to Depreciate Your Home."

If you made house repairs before your business began and they were done to help you get ready for your business, treat them as Start-Up Expenses. If you made a house repair before your business began that was unrelated to your business, you cannot deduct it.

If you know you are going to have a loss in your first year of your business, you can elect to depreciate over 15 years all of your start-up expenses. See IRS Publication 535 Business Expenses.

* Note: Technically, when I say to depreciate these items, IRS rules say to amortize them. What's the difference? In this case, amortizing means to spread the deduction over 180 months (15 years). It's possible for these months to extend over 15 years. Aren't you glad you know this?

Final Note

I've heard from several family child care providers recently that their tax preparer wouldn't allow them to claim any start-up expenses or depreciate household items they owned before their business began. You may need to insist that you want to claim deductions for both categories of expenses I described above.

If your tax preparer says you can't claim start-up expenses, tell them to read IRS Publication 535 Business Expenses.

If your tax preparer says you can't depreciate household items you owned before your business began, tell them to read the IRS Child Care Provider Audit Techniques Guide.

This Guide says: "For many providers, when they start their business many items which were personal use only are used in the business. They are entitled to depreciate the business use portion of those assets. For assets purchased prior to being placed into service, the basis for depreciation is the lower of the cost or the fair market value at the time the asset is placed in service."

Tom Copeland - www.tomcopelandblog.com

Image credit: childcarecenter.us 

For details on how to depreciate items, see my 2013 Family Child Care Tax Workbook and Organizer.

How to depreciate your house.

How to Depreciate Your Home

By Tom Copeland, posted with permission.

Every family child care provider who owns a home should depreciate it and claim a substantial tax deduction.

I've written a previous article about why you should never listen to anyone tell you not to depreciate your home.

Here's a summary of how to depreciate your home broken down into five steps.

First - Determine the portion of your home's value that you will use to depreciate. You need to use the lower of these two numbers: the purchase price of your home or the fair market value of your home at the time you first started using it in your business.

Let's say you bought your home in 2004 for $250,000 and you started your business in 2011. Look at your property tax assessment for 2011 to estimate the value of your home in 2011. If the value in 2011 was $260,000, we would use the lower $250,000 amount for depreciation.

$250,000

Note: Because of housing market decline in recent years it's possible your home was worth less when your business began than when you purchased it.

Second - Subtract the value of the land from your home value. If you are using the home value at the time you purchased your home, use the land value at that time. We will assume the land value in 2004 was $50,000.

$250,000 - $50,000 = $200,000

Three - Add to your home value any home improvements (remodeling, room additions, outdoor deck, etc.) and land improvements (fence, patio) that were done to your home before you went into business. Let's assume you added a deck in 2006 for $5,000 and remodeled your basement and bathroom for $20,000.

$200,000 + $5,000 + $20,000 = $225,000

Note: This amount will never change as long as you are depreciating your home.

Four - Multiply this adjusted value of your home by your Time-Space Percentage each year. The result is the business portion of your home that you can depreciate.

Let's say your Time-Space Percentage for 2012 was 35%:

$225,000 x 35% = $78,750

Note: If your Time-Space Percentage changes in future years this number will go up or down.

Five - Calculate the amount you can depreciate in the current year. Since 1994 you must depreciate your home over 39 years. In the first year of depreciation you will use a percentage based on the month your business began (see IRS Publication 587 Business Use of Your Home or my annual Family Child Care Tax Workbook for these percentages). After your first year in business, use 2.564%. Since you began your business in 2011, we will use this percentage for 2012.

$78,750 x 2.564% = $2,019

Claim $2,019 as your home depreciation deduction on Form 8829 Expenses for Business Use of Your Home.

As you can see, depreciating your home can represent a substantial tax deduction. If you haven't depreciated your home in past years you can either amend your tax return back three years and claim a refund, or file IRS Form 3115 to recapture unclaimed depreciation further back than three years.

Tom Copeland - www.tomcopelandblog.com

Image credit: freerealestateclipart.com

For more on how to depreciate your home, see my 2012 Family Child Care Tax Workbook and Organizer.