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what is depreciation

By Jean Murray. US Business Law / Taxes Expert

Jean Murray has the education and experience to help you become an expert in your small business, and to provide you with information about business legal and tax issues. With an MBA and a PhD in entrepreneurship, she brings almost 30 years of experience and knowledge to these important business subjects.

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At the beginning of 2014, accelerated depreciation benefits to businesses were eliminated or cut drastically. Bonus depreciation was eliminated, and Section 179 deductions were reduced from $500,000 a year to $25,000.

What is depreciation?

Depreciation is a non-cash expense that reduces the value of an asset over time. When it's stated that depreciation is "non-cash," it means that depreciation is taken as an accounting entry. and that the amount of cash held by the business is not affected. Business assets that can be depreciated include equipment, machinery, technology and computers, office furniture, buildings and improvements to buildings, leasehold improvements. and business vehicles .

Land cannot be depreciated because it appreciates instead of depreciating.

Depreciation is taken on business assets to recognize the change in value of these assets as they age. Assets depreciate for two reasons:

  • Wear and tear. For example, an auto will decrease in value because of the mileage, wear on tires, and other factors related to the use of the vehicle.
  • Obsolescence. Assets also decrease in value as they are replaced by newer models. Last year's car model is less valuable because there is a newer model in the marketplace.

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How depreciation is calculated

Depreciation is calculated as follows:

  • The original cost of the asset, including costs of acquiring the asset, transporting it, and setting it up
  • Less

    the salvage value (the "scrap" value)

  • Divided over the years of useful life of the asset. The useful life of an asset is determined by the IRS based on a schedule set up for various types of assets. Check with your tax advisor for more information on "useful life" of different classifications of business assets.

Each year of the useful life of the asset, a specific amount can be included in the business's income tax return as an expense, thus reducing the business taxable income .

As an example, office furniture is purchased by a business for $20,000. The furniture has a useful life of 10 years and a scrap value of $1000. Using straight-line depreciation (described below), the $19,000 of the cost of the furniture is divided over the 10 years of life, so $1,900 can be deducted on the business's tax return for each of the 10 years.

Depreciation and Purchase Method

It should be noted that depreciation on a business asset has nothing to do with the way the asset was purchased. Whether a business vehicle is purchased with cash or a loan doesn't affect the depreciation calculation. But, leasing an asset may affect the ability of the business to depreciate the asset. Read more about capital leases vs. operating leases. for more on this subject.

Methods of depreciation

The most common method is straight-line depreciation, in which the same amount is expensed each year. Other methods are double-declining balance and sum-of-the years'-digits.

Accelerated depreciation

Depreciation can also be accelerated, allowing a business to deduct more of the cost of the business asset in earlier years. The two most common types of accelerated depreciation are Section 179 expenses and Bonus depreciation. The amounts allowed as accelerated depreciation change each year, based on laws passed by the U. S. Congress.

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