What is Depreciation

When you buy something shiny and new, like a car, you know its value will go down as time goes on, right? Well, that decrease in value over time is called depreciation. And guess what? Businesses deal with this all the time, especially when they buy big-ticket items like machinery or buildings. Now, let’s dive into what depreciation means in more detail and how businesses go about calculating it.

What is depreciation?

Depreciation is the method by which businesses allocate the cost of tangible assets over their useful life. Think of it like how your car loses value over time. For businesses, it’s a way to match the cost of an asset with the income it generates over its lifespan.

What is an asset?

An asset is anything valuable that a business or individual owns. This could be something physical like a building or machinery or something intangible like a patent or trademark. When we talk about depreciation, though, we’re usually talking about tangible assets – those things you can see and touch.

What kind of assets can you depreciate?

According to IRS guidelines, not all assets are depreciable. Only assets with a definite lifespan, used in a business or for income production, and expected to last more than a year can be depreciated.

Common examples include vehicles, machinery, office equipment, and buildings. But remember, things like land don’t depreciate because they don’t wear out or get used up!

What is a depreciation schedule?

A depreciation schedule is like a roadmap that tells you how much value an asset will lose each year over its useful life. It includes the initial cost of the asset, its salvage value (how much it might be worth at the end of its life), and the period over which you’ll spread out the depreciation.

Types of depreciation

Straight-line depreciation:

Who uses it? Most businesses, because it’s straightforward and simple.

How it works: You deduct the same amount every year.

Example: Buy a machine for $10,000 with a lifespan of 10 years. Deduct $1,000 each year.

Double-declining balance depreciation:

Who uses it? Businesses that want to deduct more in the early years.

How it works: It’s a faster method, deducting more at the start and less over time.

Example: On that same $10,000 machine, you’d deduct $2,000 the first year, $1,600 the next, and so on.

Sum-of-the-year’s-digits depreciation:

Who uses it? Those looking for a middle ground between straight-line and double-declining.

How it works: Deductions are larger in the early years and decrease over time.

Example: For a 3-year lifespan, add the digits: 1+2+3 = 6. First-year deduction is 3/6 of the cost, the second year is 2/6, and the third is 1/6.

Units of production depreciation:

Who uses it? Industries where assets wear out based on usage, not time.

How it works: Deduction is based on actual usage or production.

Example: A truck that can last 200,000 miles, and drives 40,000 miles in a year, will depreciate 1/5 of its cost that year.

Modified accelerated cost recovery system (MACRS):

Who uses it? Many U.S. businesses, as it’s the standard IRS method.

How it works: It allows larger deductions in the early years of an asset’s life.

Example: It’s a bit complex, but essentially, IRS tables guide the depreciation amount based on the asset’s type and lifespan.

How to file depreciation

Filing for depreciation is done on your annual tax returns. You’ll need to use IRS Form 4562 to report depreciation and provide details about the asset, its cost, and the method of depreciation you’re using. It’s always a good idea to consult with an accountant or tax professional to ensure you’re doing it correctly.

Curious about how depreciation might impact your business or personal finances? Schedule a FREE consultation to get personalized advice tailored to your unique situation!