What is Depreciation?
Depreciation is the process of distributing the cost of a tangible (touchable) asset over its lifetime.
The value of an asset decreases over time due to wear and tear, weather, or simply because it becomes outdated.
Depreciation and amortization are words that every business owner must understand because they affect both the value of the business and the tax payable on income.
Both words describe the way in which the value of an asset reduces over time. The difference is that:
- Depreciation is related to tangible assets (those you can touch)
- Amortization to intangible assets (those you can’t)
Why depreciate assets
If not for depreciation, the entire cost of an asset would be documented the first year. This is not in line with how the asset benefits the company in profits.
If an asset is useful to your business for less than one year, the IRS lets you deduct the entire purchase price of that asset from your taxable income in the year in which it is bought.
In all other cases, you can deduct only part of the purchase price. The taxable income—the amount on which the business will pay tax—is calculated each year by deducting part of the cost of the asset from the profit.
This “write-off” is called depreciation.
Calculator: How to retire a millionaire?
Types of Depreciation
|Straight line||Equal amount every year|
|Declining balance||Starts off higher and ends lower|
|Sum of the year’s digits||Add the digits in the number of years total (so 5 years: 1+2+3+4+5 = 15), and then divide each year by that number, but flip it around to start with the last year number first.|
Year 1: 5 /15 = 33.34%
Year 2: 4 /15 = 26.67%
Year 3: 3 /15 = 20%
Year 4: 2 /15 = 13.33%
Year 5: 1/15 = 6.67%
- Unit of production: Varies depending on activity/use of the asset
How it is calculated
It is set by the IRS, and the taxpayer must complete Form 4562 to show how the amounts claimed for both depreciation and amortization have been calculated.
- A new car loses 11% of its value the moment you leave the lot.
- The date you acquire an asset is not always the date on which depreciation begins. What counts is not when you buy it but when you start to use it.
- Depreciation is permitted on buildings but not on land because land is assumed not to lose value.