depreciation

(redirected from depreciations)
Also found in: Dictionary, Thesaurus, Medical, Financial, Encyclopedia.

Depreciation

The gradual decline in the financial value of property used to produce income due to its increasing age and eventual obsolescence, which is measured by a formula that takes into account these factors in addition to the cost of the property and its estimated useful life.

Depreciation is a concept used in accounting to measure the decline in an asset's value spread over the asset's economic life. Depreciation allows for future investment that is required to replace used-up assets. In addition, the U.S. Internal Revenue Service allows a reasonable deduction for depreciation as a business expense in determining taxable net income. This deduction is used only for property that generates income. For example, a building used for rent income can be depreciated, but a building used as a residence cannot be depreciated.

Depreciation arises from a strong public policy in favor of investment. Income-producing assets such as machines, trucks, tools, and structures have a limited useful life—that is, they wear out and grow obsolete while generating income. In effect, a taxpayer using such assets in business is gradually selling those assets. To encourage continued investment, part of the gross income should be seen as a return on a capital expenditure, and not as profit. Accordingly, tax law has developed to separate the return of capital amounts from net income.

Generally, depreciation covers deterioration from use, age, and exposure to the elements. An asset likely to become obsolete, such as a computer system, can also be depreciated. An asset that is damaged or destroyed by fire, accident, or disaster cannot be depreciated. An asset that is used in one year cannot be depreciated; instead, the loss on such an asset may be written off as a business expense.

Several methods are used for depreciating income-producing business assets. The most common and simplest is the straight-line method. Straight-line depreciation is figured by first taking the original cost of an asset and subtracting the estimated value of the asset at the end of its useful life, to arrive at the depreciable basis. Then, to determine the annual depreciation for the asset, the depreciable basis is divided by the estimated life span of the asset. For example, if a manufacturing machine costs $1,200 and is expected to be worth $200 at the end of its useful life, its depreciable basis is $1,000. If the useful life span of the machine is 10 years, the depreciation each year is $100 ($1,000 divided by 10 years). Thus, $100 can be deducted from the business's taxable net income each year for 10 years.

Accelerated depreciation provides a larger tax write-off for the early years of an asset. Various methods are used to accelerate depreciation. One method, called declining-balance depreciation, is calculated by deducting a percentage up to two times higher than that recognized by the straight-line method, and applying that percentage to the undepreciated balance at the start of each tax period. For the manufacturing machine example, the business could deduct up to $200 (20 percent of $1,000) in the first year, $160 (20 percent of the balance, $800) the second year, and so on. As soon as the amount of depreciation under the declining-balance method would be less than that under the straight-line method (in our example, $100), the straight-line method is used to finish depreciating the asset.

Another method of accelerating depreciation is the sum-of-the-years method. This is calculated by multiplying an asset's depreciable basis by a particular fraction. The fraction used to determine the deductible amount is figured by adding the number of years of the asset's useful life. For example, for a 10-year useful life span, one would add 1, 2, 3, 4, 5, 6, 7, 8, 9, and 10, to arrive at 55. This is the denominator of the fraction. The numerator is the actual number of useful years for the machine, 10. The fraction is thus 10/55. This fraction is multiplied by the depreciable basis ($1,000) to arrive at the depreciation deduction for the first year. For the second year, the fraction 9/55 is multiplied against the depreciable basis, and so on until the end of the asset's useful life. Sum-of-years is a more gradual form of accelerated depreciation than declining-balance depreciation.

Depreciation is allowed by the government as a reward to those investing in business. In 1981, the Accelerated Cost Recovery System (ACRS) (I.R.C. § 168) was authorized by Congress for use as a tax accounting method to recover capital costs for most tangible depreciable property. ACRS uses accelerated methods applied over predetermined recovery periods shorter than, and unrelated to, the useful life of assets. ACRS covers depreciation for most depreciable property, and more quickly than prior law permitted. Not all property has a predetermined rate of depreciation under ACRS. The Internal Revenue Code indicates which assets are covered by ACRS.

Further readings

Brestoff, Nelson E. 1985. How to Write Off Your Down Payment. New York: Putnam.

Hudson, David M., and Stephen A. Lind. 1994. Federal Income Taxation. 5th ed. St. Paul, Minn.: West.

Cross-references

Income Tax; Taxable Income.

depreciation

n. the actual or theoretical gradual loss of value of an asset (particularly business equipment or buildings) through increasing age, natural wear and tear, or deterioration, even though the item may retain or even increase its replacement value due to inflation. Depreciation may be used as a business deduction for income tax reduction, spread out over the expected useful life of the asset (straight line) or at a higher rate in the early years of use (accelerated).

See: contempt, criticism, damage, decline, decrease, denunciation, depression, deterioration, diatribe, disapprobation, disdain, disparagement, disregard, disrespect, revilement, stricture, wear and tear

depreciation

the accounting practice whereby the cost of a fixed asset is written off over the period of its expected useful life. The amount written off is a recognized deduction in computing the profits of a business. It is not allowable for tax purposes but CAPITAL ALLOWANCES may be given.
References in periodicals archive ?
Another important function of the section 1016(a)(2) basis reduction by all allowable depreciation deductions is to prevent a taxpayer from having a second chance to receive the tax benefit of a depreciation deduction that did not produce a tax benefit in the tax year it was properly deductible.
So if a depreciation deduction would not produce a tax benefit in its properly deductible tax year, the taxpayer does not have the option of skipping the deduction for that year; thus, not reducing the underlying asset's basis.
Further assume that in the first year, the taxpayer is entitled to an allowable depreciation deduction of $20.
Preventing a Taxpayer from Receiving the Tax Benefit of a Nonexistent Loss when Tax Depreciation Exceeds Economic Depreciation
Unlike the harsh punitive tax consequences of the Basis Reduction Tax Trap, if tax depreciation deductions that produce corresponding tax benefits exceed the economic depreciation of the underlying depreciable asset, the section 1016(a)(2) basis reduction precludes the taxpayer from enjoying the unwarranted tax benefit of a deduction for a nonexistent economic loss.
To illustrate this point, consider the following fact pattern: a taxpayer acquires a depreciable asset for $100 and claims in the first year a $20 depreciation deduction that reduces her taxable income by a like amount; in the second year, the taxpayer sells the asset for its original cost of $100.
Because the asset's basis was reduced by the $20 tax depreciation deduction, the subsequent sale of the asset resulted in a taxable gain of $20 (37) Thus, the unwarranted tax benefit of a depreciation deduction for a nonexistent economic loss would be effectively reversed or offset by a corresponding amount of gain triggered by the sale of the depreciable asset.
Preventing a Taxpayer Who Claims Excessive Depreciation Deductions that Produce Tax Benefits from Over-Depreciating the Property's Original Cost
A taxpayer who claims depreciation deductions in excess of the allowable amount that reduces taxable income receives an unwarranted tax benefit.
39) Further assume that in the first four years of the recovery period, the taxpayer claimed an aggregate amount of $100 of depreciation deductions (all of which reduced taxable income by a like amount) or $20 more than the allowable amount of $80 over that period.