The concept of depreciation is simple: You bought a huge sofa for your home business. The minute you sit on it, the piece of furniture loses some of its worth. The passage of time causes the sofa to wear and tear, and each year that you own and use it, it costs less that it actually was. Measuring the reduction in worth of an asset is known as depreciation.
Depreciation is an accounting method of spreading the recorded cost of a physical or tangible asset over its useful life. It is something you use to write down the value of long-term assets that you acquire for business or investment purposes.
Why is it important to you as a property investor? Depreciation is one way of obtaining tax benefits. By depreciating assets, you can generate tax deductions and put off tax payments to a later time.
Amortization VS Depreciation
Amortization and depreciation both refer to spreading an asset’s cost over that asset’s useful life. The key difference, however, is amortization charges off the cost of an intangible asset, or an asset that is non-monetary and not physical in nature. Corporate intellectual properties, like patents, copyrights, brand identity, and trademarks are considered intangible assets.
Depreciation, on the other hand, does so for tangible assets, or the ones with a physical form. Nearly all tangible assets can lose their value, be depreciated, and be sold at a reduced cost. Some examples are buildings, furniture, machinery, office equipment, and home or leasehold improvements.
- What cannot be depreciated
Land, on the other hand, is a tangible asset that isn’t considered as an expense and therefore cannot be depreciated. Unlike other tangible assets like a building or an office equipment, it does not wear out over time. In fact, it is considered to have an infinite useful lifespan.
Factors To Consider When Calculating Depreciation
It refers to the time period over which the company or the property investor expects the asset to be productive. Every item you purchase has a lifespan. Once it gets past its useful life, operating the particular asset will no longer be cost-effective and it is expected to be disposed of.
When an owner decides to dispose of an asset, it can be sold for some significantly reduced amount. That amount is called the salvage value.
Depreciation is calculated based on the cost of an asset less any estimated salvage value. Various methods can be used in calculating depreciation but the most common method is the straight line method.
Using Straight Line Depreciation Method
It is considered as the primarily used method. To compute the amount of annual depreciation expense, you have two major factors to keep in mind: the initial cost of the asset (purchase price) and its estimated useful life.
How to calculate:
1. Determine the asset’s initial cost
If you purchased a quite expensive kitchen equipment for $1,000, the said amount would be your initial cost.
2. Determine the depreciable cost
You can find the depreciable cost by subtracting the salvage value from the asset’s initial cost. Like we previously mentioned, the salvage value represents how much your asset will be worth once it’s outlived its usefulness.
Let’s say it’s determined that the kitchen equipment would cost only $300 at the end of its lifespan. You may say that the depreciable cost is $1,000 – $300 = $700.
3. Get the total depreciation by dividing the depreciable cost by the asset’s lifespan
You have to know how many years you can expect to make use of your new asset effectively. Once you know its expected lifespan, divide the depreciable cost by that number.
For instance, if you have $700 as your depreciable cost and you expect your kitchen equipment to last 7 years, then the depreciation is $700 / 7 (years) = $100. That’s the amount of depreciation you’ll put in your accounting books annually.
Carmina Natividad is a savvy writer for Depreciator, an Australian-based business specializing in Tax Depreciation Schedules. Being an enthusiast of pursuing financial security herself, she writes and shares self-help articles focused on personal finance, tax planning, and property investing.
March 31, 2017