Definition: An expense item set up to express the diminishing life expectancy
and value of any equipment (including vehicles). Depreciation is
set up over a fixed period of time based on current tax regulation.
Items fully depreciated are no longer carried as assets on the
company books.
Wear and tear, age, deterioration and obsolescence are a few of
the reasons why property depreciates in value. By taking a
deduction for depreciation on your tax return, you can recover the
cost of certain property or equipment you use in your business or
for the production of income.
If you buy a piece of equipment, depreciation of its original
cost should be included as an expense on your monthly operating
statement. If you lease a piece of equipment, the monthly lease
payment is part of your monthly operating expenses (cash-value
depreciation is frequently figured into the cost of an equipment
lease and need not be figured separately by you).
Many equipment-leasing agreements have a clause providing for
what's known as a "depreciation reserve." This consists of setting
aside money commensurate with the declining value of the vehicle.
When the lease is up, the equipment is sold to either the lessee or
another third party. If it goes for a price over and above its
depreciated value, the difference can be refunded to the lessee.
If, however, the equipment is sold for a price under its
depreciated value, the lessee must pay the difference to the
lessor. This is where the depreciation reserve comes in handy.
Straight-line or uniform depreciation is the most frequently
used method of depreciating new equipment for financial statements.
In straight-line depreciation, the equipment loses an equal part of
its total value every year of its life. For your tax return,
though, your accountant will most often use a tax-approved
depreciation that gives you the largest deduction on your tax
return and goes farther in minimizing your taxes.
Suppose you buy a $15,000 printing press with a ten-year useful
life, according to your accountant's schedule. The straight-line
depreciation rate is calculated by dividing its ten years of useful
life into the $15,000, or $1,500 a year. If you're in the 28
percent tax bracket, $1,500 in depreciation will save you $420 in
taxes. Suppose you only need 20 percent down to buy a $15,000
machine. Suppose, too, that you financed your press on the
installment plan. The interest you pay on any amount owed is going
to be another deduction for you. So if you have a $12,000 loan that
costs $1,200 in interest, you'll wind up with another $336 (in the
28 percent bracket) in savings.
The current methods of depreciation are often referred to as
MACRS (modified accelerated cost recovery system), whereas the
method used for any assets acquired before December 31, 1986 is
often called ACRS (accelerated cost recovery system). Assets used
in your trade or business that were purchased before that time are
depreciated using different methods than those discussed here.
Those earlier methods generally provided a larger depreciation
deduction than the current rates.
Keep in mind that many states have different sets of rules than
those used on your federal income tax return for allowable
depreciation methods on state tax returns. You should check with
your tax professional to find out more about the rules in your
state.