In an earlier blog post I mentioned that the optimum moment in which a practice should update its technology (assuming that the practice has not continually updated technology over its life span) is about 7 years prior to a potential sale. Part of the reason why 7 years is suggested is so the doctor buying the new dental equipment can fully benefit from the depreciation deductions associated with the purchase of said equipment. This point requires further explanation.
The Internal Revenue Code (relevant sections are 167, 168, 179, with a host of other publications and regulations) allows for businesses to take depreciation deductions on most business equipment purchased for use in the business. Generally, most tangible items which are used in the business, but not which are sold to customers or patients, are deductible. For dental practices this means computers, lighting fixtures, digital x-ray sensors, furniture, chairs, vehicles, and operatory equipment all create depreciation deductions. Inventories and land do not create deductions as the property creating the deductions must be used in a trade or business or be "property held for the production income". However, the amount deductible in a given year is subject to calculation, and in part explains why 7 years prior to a sale is the ideal time to purchase new equipment.
There are two main methods used to determine the amount of a depreciation deduction in a given year: the “Straight Line Method” and “Double Declining Balance Method." The Double Declining method is usually preferred because it allows the business to deduct greater amounts in a shorter time than the Straight Line Method; this translates to more deductions more quickly, which has obvious appeal.
Both methods adhere to certain rules and concepts promulgated by IRS publications which need to be understood before an explanation of each of the methods. First, every piece of property has a "useful life" as determined by the treasury. The useful lives are listed in Publication 946 and its exhibits and amendments. For dentists, the useful life of a property is a fiction, and merely translates into the amount of years in which the property may be deducted. Thus an panoramic x-ray may have a "useful life" of 7 years under the regulations, but in reality the machine will probably work for 30 years. The vast majority of equipment used in a dental office is depreciable over a period of 7 years, with the remainder usually depreciable over 5 years. There are rare exceptions to this rule, but to recover the full value of depreciation deductions, the owner of the equipment should seek to own the equipment for the full useful life of the equipment. The next important concept is tax basis, the purposes of depreciation deductions it's fair to say that the tax basis is the cost of the property to the business (provided an even-handed business transaction). The basis is reduced every time a depreciation deduction is taken. Finally, to understand two types of depreciation you must understand the "6 month convention". The 6 month convention, which is required under the tax code, requires a deduction to be taken at 50% of its normal amount 6 months into the first year of the property's use by the business, and again 6 months after the end of the useful life. The effect is that a 5 year property will actually be deductible in 6 periods, a 7 year property in 8 periods. This point is better illustrated by example.
The Double Declining Balance Method builds on the concepts of the Straight Line Method and was designed so business could more quickly recapture the depreciation, or in other words, so they could get deductions more quickly. Using the same $500,000 example here is what the Double Declining Balance Method looks like:
The above examples clearly show the utility of a Double Declining Balance Depreciation. By the end of year two, the Double Declining Balance method had provided $260,000 in deductions, where as the straight line method had provided only $150,000 in deductions. As noted above, it's important to keep in mind that most dental equipment is depreciable over a 7 year period. The numbers used in the examples above assume a 5 year period. Also, the examples above use a lofty $500,000 piece of property, and in the dental world even the fanciest big ticket items are usually less than $100,000. There are other depreciation rules to consider, and the rules are always changing so make sure you talk to a qualified accountant or attorney ( like those at Dental Transitions) before preparing your taxes.
Both methods adhere to certain rules and concepts promulgated by IRS publications which need to be understood before an explanation of each of the methods. First, every piece of property has a "useful life" as determined by the treasury. The useful lives are listed in Publication 946 and its exhibits and amendments. For dentists, the useful life of a property is a fiction, and merely translates into the amount of years in which the property may be deducted. Thus an panoramic x-ray may have a "useful life" of 7 years under the regulations, but in reality the machine will probably work for 30 years. The vast majority of equipment used in a dental office is depreciable over a period of 7 years, with the remainder usually depreciable over 5 years. There are rare exceptions to this rule, but to recover the full value of depreciation deductions, the owner of the equipment should seek to own the equipment for the full useful life of the equipment. The next important concept is tax basis, the purposes of depreciation deductions it's fair to say that the tax basis is the cost of the property to the business (provided an even-handed business transaction). The basis is reduced every time a depreciation deduction is taken. Finally, to understand two types of depreciation you must understand the "6 month convention". The 6 month convention, which is required under the tax code, requires a deduction to be taken at 50% of its normal amount 6 months into the first year of the property's use by the business, and again 6 months after the end of the useful life. The effect is that a 5 year property will actually be deductible in 6 periods, a 7 year property in 8 periods. This point is better illustrated by example.
The Double Declining Balance Method builds on the concepts of the Straight Line Method and was designed so business could more quickly recapture the depreciation, or in other words, so they could get deductions more quickly. Using the same $500,000 example here is what the Double Declining Balance Method looks like:
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