Depreciation is a non cash expense that reduces the value of an asset as a result of wear and tear, age or obsolescence. Most assets lose their value over time and must be replaced once the end of their useful life is reached.
Imagine you have own an Ice cream Business. You purchased the ice cream machine for $5000. If the machine life time is 5 years then the depreciable value every year is $5000/5 = $1000. How did I arrive at 5 years as the life time. Let us see the Excerpt from Charlie Munger’s – Elementary Worldly Wisdom
But you have to know enough about it to understand its limitations—because although accounting is the starting place, it’s only a crude approximation. And it’s not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn’t make it anything you really know.
To calculate the depreciation take the purchase price of the asset and divide it by its life time. In this example it is $5000/5 = $1000. This way of arriving at the value is called as Straight Line Depreciation.
What do you do with $1000
If you generate a Sales of $3000 from the Business and your expenses comes to $1000 then without depreciation your taxable income comes to $3000 – $1000 = $2000. With depreciation your taxable income will be $3000 – $1000 – $1000 = $1000.
Is $1000 Depreciation really a non cash expense
To understand if depreciation is really an expense I read the Berkshire Hathaway – 2002 Letter to the Shareholder. Here is the Excerpt
Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?
At the end of year 5 if the machine becomes obsolete then you have two choices (1) close the business (2) buy a new ice cream machine. If you are going to buy a new machine where is the money going to come from? Hence I am convinced that depreciation is really an expense.
I do not own an ice cream Business why do I care? Well Rental Property can also be depreciated.
Residential property is depreciated over 27.5 years. IRS sets the number of years (approximation). Is the property not usable after 27.5 years. The rented apartment I live in Bay Area is 50+ years old.
Property has 2 components to it. Land and Building. Land is not depreciable because it does not wear out. Only the amount paid to the building is. How do you know how much is the building alone worth? Refer to Publication 527 for complete information.
Purchase price for the property = $200,000 Tax assessment for the property = $160,000 (Tax Authority does) Value of the Land = $20,000 (Tax Authority does) Value of the Building = $140,000 (Tax Authority does) Land value in percentage = $20,000/$160,000 = 12.5% Building value in percentage = $140,000/$160,000 = 87.5% Total Depreciation = Purchase Price * Building value in percentage = $200,000 * 0.875 = $175,000 Annual Depreciation = $175,000/27.5 = $6363.63 per year
Wow I can own a property for few years and reduce my taxable income using depreciation and then sell it and repeat this process. Hold on if you sell a property the depreciation is recaptured.
Let us say you sold the property for $300,000 after holding it for 10 years. How much taxes do you owe.
Profit = $300,000 - $200,000 = $100,000(Federal Tax 15% long term) Total Depreciation = $63,636.30 (Maximum Recapture rate at 25%) Total Federal Tax = $100,000 * 0.15 + $63,636.30 * 0.25 = $15,000 + 15,909 = $30,909
You can defer paying taxes if you reinvest the proceeds in like-kind property. This is called as 1031 exchange. Refer to the IRS website for more information on 1031 exchange.