Amortization can be a confusing tax term. It's similar to depreciation, and it works like depreciation, but it's used for different kinds of business assets.
Amortization actually has several meanings. In relation to loans, it's the process of paying down the loan by making payments, which include both principal and interest. Amortization of expenses spreads out the expense of an asset over its useful life for tax purposes.
- Amortization deals with intangible assets, whereas depreciation deals with tangible assets.
- With loans, amortization refers to your schedule for paying off the loan with payments that include interest and principal.
- For business purposes, you use amortization to expense the cost of intangible property over the course of the property's useful life.
- Businesses can use amortization of expenses to lower their tax liability.
Amortization vs. Depreciation
Depreciation and amortization use essentially the same process but for different types of assets. While depreciation expenses the cost of a tangible asset such as a piece of equipment over its useful life, amortization deals with expensing intangible assets like trademarks or patents. Amortization is similar to straight-line depreciation—the cost of the asset is spread out in equal increments over the years of its useful life.
How Amortization Works for Loans
An amortization schedule is often used to show the amount of interest and principal that's paid on a loan with each payment. It's basically a payoff schedule showing the amounts paid each month, including the amount that's attributable to interest and a running total for the interest paid over the life of the loan.
You can use an online loan amortization calculator to find the monthly payment on a loan before you commit to it. You'll need to know the amount of the loan, the interest rate, the amount of any deposit you intend to put down, and the term or length of the loan. You can then get an estimate of what the monthly payment will be.
For example, if you take out a $400,000 loan for 15 years with 20 percent down at a 5.25 percent interest rate, the monthly payment will be approximately $1,881. For mortgages, interest will make up a big chunk of your initial payments, but, over time, more of your payment will go toward the principal.
How Amortization Works for Intangible Assets
You'll need the value of the asset and its estimated useful life to calculate amortization for an asset. Its useful life is the time period over which it's expected to be of use to your business.
The amount amortized is the same for each year so the calculation is relatively simple. For example, a company might have a patent that it spent many years and $1 million in costs to develop. The patent's useful life is estimated at 15 years, so the company can claim $66,667 in amortization expenses each year—$1 million divided by 15.
In general, an asset is intangible if it has no physical substance, is non-financial (e.g. not a security), and has a lifespan of more than one tax reporting cycle.
Calculating Amortization for Tax Purposes
Amortization is a legitimate expense of doing business and this expense can be used to reduce your company's taxable income. The current year's amortization expenses, like depreciation expenses for the year, should appear on your company's income statement or profit and loss statement.
An amortization calculation is included when a company prepares its income tax return for all allowable assets that are being amortized. You'll use IRS Form 4562 for the calculation. The form includes both depreciation and calculation of depreciation for a listed property as well as amortization.
Depreciated assets are listed first, then assets that are amortized are listed next. The calculations are then transferred to the main tax return form, which can vary depending on the type of business.
How Business Startup Costs Are Amortized
Business startup costs are treated somewhat differently. The IRS requires that you amortize startup costs, but it does allow up to $5,000 of startup costs to be deducted during the first year of business.
Frequently Asked Questions (FAQs)
What is an example of an amortization expense?
Your company owns a patent that has a useful life of 10 years. The patent cost you $1 million to develop and obtain. So, you amortize the expense at a rate of $100,000 per year for 10 years.
Why do we amortize expenses?
Amortization helps business reduce their tax liability as they acquire and create intangible assets that can help them grow and succeed.