What Is Depreciation? How It Works and Why It Matters

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Depreciation is the recovery of the cost of a physical asset, like property or equipment, over multiple years. It allows companies to spread out the cost of some expenses, reduce taxable income and manage long-term investments. Here’s everything you need to know about depreciation — how it works, how to calculate it and how it impacts taxes. 

What Is Depreciation?

Assets like equipment, vehicles and furniture lose value as they age. Parts wear out, and pieces break, eventually requiring repair or replacement. Depreciation helps companies account for the declining worth of their assets.

Why Depreciation Matters in Business

Consider this:

• A company buys equipment for $100,000 to manufacture its product.
• It deducts the full $100,000 as a business expense in the same year.
• That year, the company generated $500,000 in sales.
• After all expenses, it shows a $100,000 profit.
• The following year, it brought in $300,000 in sales.
• Since the equipment cost was already fully deducted, the profit appears artificially high, even though the equipment is still in use.

Depreciation allows the company to spread the expense over the equipment’s life, resulting in a more accurate picture of the company’s profitability in high- and low-revenue years.

How Depreciation Affects Accounting and Taxes

Accounting professionals understand how depreciation impacts financial statements and use this knowledge to analyze a company’s financial health. This strategy helps align assets with the revenue they generate for the business.

Depreciation impacts businesses in several additional ways.

• Reduces taxable income.
• Appears as a non-cash expense on the income statement.
• Affects the book value of assets on the balance sheet.
• Impacts financial ratios and profit calculations.

Common Methods of Depreciation

There are multiple ways to calculate depreciation, each suited to different asset types and financial strategies. Here are some of the most commonly used methods.

Straight-Line

This straight-line depreciation method evenly distributes the asset’s cost over its useful life. It works well for assets like property that tend to depreciate predictably each year.

• Formula: (Cost of asset – salvage value) / Useful life
• Example: You own a rental building that costs $300,000, and its salvage value is $100,000. The building has a useful life of 25 years. The straight-line depreciation is $8,000.

Declining Balance

With this accelerated depreciation, you deduct a greater portion of the asset’s value at the beginning of its life — typically at a rate of double or 150%. 

Front-loading the expense earlier in the asset’s useful life can benefit assets that lose value faster, such as electronics and high-tech equipment.

• Formula: Beginning book value x Depreciation rate
• Example: Say you own a bakery and have a machine in the kitchen with a beginning book value of $100,000. The depreciation rate is 10%. The declining balance deduction is $10,000. 

Sum-of-the-Years Digits

Another accelerated method, this approach applies a different rate each year to calculate the asset’s depreciable amount.

It typically results in higher depreciation in the early years and progressively lower amounts later. It is often used for assets that lose value faster early on, such as vehicles or machinery.

• Formula: (Asset lifespan remaining / Sum of the years digits) x (Original cost – salvage value)
• Example: You have a construction business and own a truck costing $60,000. The salvage value is $10,000. The car has a 5-year useful lifespan, so the sum-of-the-years digit is 15. The depreciation value for the first year is $16,666. 

Units of Production 

This method ties depreciation to actual asset usage instead of the amount of time it’s in use. It is a good choice for assets that wear out based on production levels, like machinery that depreciates based on hours used or units produced.

The method applies the greatest rates during years when you use it most.

• Formula: (Asset cost – salvage value) / Total number of produced units
• Example: Suppose you have a manufacturing machine for your business that costs $30,000. The salvage value is $5,000. The machine will produce 10,000 units. The depreciation per unit is $2.50. 

Depreciation for Tax Purposes

Depreciation offers significant tax advantages for businesses by allowing them to deduct the cost of tangible assets over time. The IRS lists the following guidelines to help you determine which items you own qualify:

• You must own the property.
• You must use the property to generate income.
• You must specify the asset’s useful life.
• You must anticipate using the asset for at least one year.

Here are some other key points to know:

• You can depreciate the cost of an office building you purchase for your business but not the monthly lease payment if you rent one.
• You cannot depreciate the cost of a vehicle you use as a personal vehicle, even if the company purchased it for you. 
• Inventory and office supplies, such as paper and printer ink, cannot be depreciated because they are typically consumed in less than a year.

What Is Accelerated Depreciation?

Accelerated depreciation enables businesses to take larger deductions early in an asset’s life, reducing taxable income upfront. This method is particularly useful for assets like technology, which lose value quickly. 

For example, under MACRS, computers or machinery may be depreciated at a 200% declining balance rate. This allows for higher deductions in the early years and improved cash flow for reinvestment.

Benefits of Accelerated Depreciation

• Immediate tax benefits by lowering taxable income.
• Larger deductions in the early years of an asset’s life. 
• Improved cash flow to reinvest in business growth.

Common Types of Accelerated Depreciation

Here’s a look at some of the most common types of accelerated depreciation.

Depreciation in Real Estate

Depreciation in real estate refers to deducting the value of a property’s structure over time, not its land. Land does not meet the requirements for depreciation because it does not have a limited life span and cannot become obsolete. 

Real Estate Depreciation Example

Say you purchase a rental property for $500,000. You can depreciate the cost of the physical property. If the value of the land is $50,000, you can depreciate the remaining $450,000. 

Using a straight-line depreciation method, you could deduct $16,363 from the taxable income each year for the next 27.5 years. However, you can only use this as long as you still own the property.

Key Facts for Real Estate Investors

• Depreciation recapture: When selling a depreciated property, investors face a depreciation recapture tax. This is how the IRS gets paid the taxes you didn’t pay when you depreciated the property during your ownership.
• Capital gains: You pay capital gains taxes on the profit you make on the sale. It’s typically lower than the ordinary income tax if you owned the property long enough to qualify as a long-term asset. 
• Land value: Land is not depreciable, only the structures on the property.

Depreciation vs. Amortization

Depreciation and amortization both allocate the cost of assets over time. However, they apply to different types of assets.

• Depreciation: This applies to tangible assets, like buildings, machinery and vehicles. These physical assets lose value due to wear and tear or obsolescence.
• Amortization: This applies to intangible assets, like patents, trademarks and goodwill. While non-physical, these assets also provide value over time.

How To Calculate Depreciation: Step-by-Step

1. Determine the asset’s cost. Include the purchase price and any additional costs like installation or shipping.
2. Estimate the salvage value and lifespan. This is the asset’s estimated value after it’s no longer helpful. Consider how much it will cost to dispose of the asset properly, and remember that a tangible asset’s salvage value must be at least zero. Technological advances and legislation can impact the useful life of intangible assets or make them obsolete.
3. Choose a depreciation method. The method you choose depends on several factors, including the type of asset and business needs.
4. Calculate the depreciation expense. Apply your chosen method to calculate the annual depreciation.
5. Record depreciation. Record this annually on the income statement and update the accumulated depreciation on the balance sheet.

Takeaway

Depreciation helps manage the cost of long-term assets. It’s a helpful financial tool for business owners, real estate investors and accountants. Once you know how depreciation works, you can make changes to lower your taxes, make smarter spending decisions and position your company for long-term success. 

Allison Hache contributed to the reporting for this article.

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