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 deduc-
tion 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-produc-
ing assets such as machines, trucks, tools, and
structures have a limited useful life—that is,
they wear out and grow obsolete while generat-
ing 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 com-
puter 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 sub-
tracting the estimated value of the asset at the
end of its useful life, to arrive at the depreciable
basis. Then, to determine the annual deprecia-
tion for the asset, the depreciable basis is divided
by the estimated life span of the asset. For exam-
ple, 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 depreci-
ation. One method, called declining-balance
depreciation, is calculated by deducting a per-
centage up to two times higher than that recog-
nized by the straight-line method, and applying
that percentage to the undepreciated balance at
the start of each tax period. For the manufactur-
ing 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 deprecia-
tion is the sum-of-the-years method. This is cal-
culated 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 use-
ful 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 depre-
ciation deduction for the first year. For the sec-
ond 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 deprecia-
ble 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 pre-
determined 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.
