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Definition of Depreciation:
is a measure of the amount a capital good is used up over a period of time due to wear and tear or becoming obsolete.
Is your two year old car worth as much today as when you purchased it? Probably not. Your car has depreciated in value. In other words, it is worth less because its useful life is shorter. If you purchased your car for $20,000 and it is now worth $10,000, your car has depreciated $10,000.
In accounting, depreciation measures the used up capital. If an asset is used to generate income over several years, the tax payer is normally not permitted to deduct the entire purchase in the year the asset was acquired. Instead, the cost can be recovered over the life of the asset. This is a depreciation expense. In the initial year when the asset is purchased the cash spent exceeds the amount of depreciation. However, in future years, no cash is spent, but depreciation is permitted. Depreciation reduces a company’s taxable income.
To illustrate the concept of depreciation, assume you purchased some equipment for your business. You paid $18,000, and its useful life is five years. After five years you anticipate selling it for $3,000. You choose to use the straight-line method of depreciation which allows you to depreciate your equipment $3,000 per year, for the next five years. (The calculation would be ($18,000 - $3,000) / 5.) Now assume your business generates an income of $73,000 every year before depreciation. In the initial year your business would have generated $73,000 from operations. You paid $18,000 for the equipment, so your positive cash flow equaled $55,000 ($73,000 income less $18,000 for the equipment). Your taxable income would equal $70,000 ($73,000 - $3,000). Your cash flow is less than your income. However, your taxable income would be less than your cash flow in the following years. In years 2 – 5, your business would generate a positive cash flow of $73,000 (as opposed to $55,000 in the first year), but you could deduct $3,000 for depreciation, so your taxable income would equal $70,000. (Note this is to illustrate the concept of depreciation. Consult with your accountant for the appropriate calculation and treatment.)
The IRS manual
In order for a taxpayer to be allowed a depreciation deduction for a property, the property must meet all the following requirements:
- The taxpayer must own the property. Taxpayers may also depreciate any capital improvements for property the taxpayer leases.
- A taxpayer must use the property in business or in an income-producing activity. If a taxpayer uses a property for business and for personal purposes, the taxpayer can only deduct depreciation based only on the business use of that property.
- The property must have a determinable useful life of more than one year.
Economic depreciation refers to a decline in the value of an asset resulting from market conditions. For example, a stock’s price may fall. This is a depreciation in value, but this depreciation is not caused by the use of the stock, so the Internal Revenue Service does not permit the depreciation to be taken over a period of years. (The decrease in value can be written off as a capital loss when the stock is sold.) An asset that increases in value appreciates. Real estate is an asset that normally appreciates, but the Internal Revenue Service permits the depreciation of the value for income producing properties. This favorable treatment is one of the most attractive features of real estate investment.
Depreciation is frequently used when discussing changes in exchange rates. A currency depreciates when the value of one currency declines relative to another. For example, assume that $1.00 is initially valued at €1.0. Six months later $1.50 is valued at €1.00. This means that more dollars are needed to purchase a given number of euros. The value of the dollar has depreciated relative to the euro. This means that the euro has appreciated relative to the dollar. When it takes more of Currency A to purchase Currency B, Currency A has depreciated, and Currency B has appreciated.
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