Depreciation (Accounting)

Definition

Depreciation (Accounting) is the process of spreading out the cost of a tangible asset over its estimated useful life. This accounting method is used to allocate the expense associated with the use of the asset on the income statement over multiple periods. Depreciation does not reflect a real loss of value but is a systematic allocation of cost.

Examples

Residential Property: Emily buys a residential rental property for $300,000. The building appraisal is $200,000, and the land value is $100,000. For tax purposes, Emily can depreciate the building value of $200,000 over 27.5 years, resulting in an annual depreciation deduction of $7,273.
Commercial Property: Johnson & Co. purchases a commercial office space for $900,000. The value attributed to the building is $700,000 with the remaining $200,000 for the land. For accounting purposes, the company can depreciate the building value over 39 years, leading to an annual depreciation amount of approximately $17,949.

Frequently Asked Questions (FAQs)

What assets can be depreciated?

Assets that can be depreciated typically include buildings, machinery, vehicles, computers, and office furniture. Land cannot be depreciated as it does not lose value over time.

What is the difference between depreciation and amortization?

Depreciation refers to the allocation of the cost of tangible assets over their useful lives, whereas amortization refers to expensing intangible assets such as patents or trademarks over time.

What are the common methods of depreciation?

The most common methods of depreciation are the Straight-Line Method, Declining Balance Method, Sum-of-the-Years-Digits Method, and Units of Production Method.

Can depreciation be claimed on personal property?

No, depreciation can only be claimed on property that is used for business, income-producing activities, or investment purposes.

How is the useful life of an asset determined?

The useful life of an asset is typically determined by factors such as the asset’s expected usage, wear and tear from that usage, the asset’s physical condition, and technological advancements.

Amortization: The process of spreading the cost of an intangible asset over its useful life.
Useful Life: The period over which an asset is expected to be used by an entity.
Salvage Value: The estimated residual value of an asset at the end of its useful life.
Accumulated Depreciation: The total of all depreciation expenses charged to an asset since it was acquired.
Book Value: The value of an asset as recorded on the financial statements, calculated as the cost of the asset minus accumulated depreciation.

Online Resources

References

Internal Revenue Service. (2023). Publication 946: How to Depreciate Property.
“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield.

Suggested Books for Further Studies

“Depreciation: Fundamentals and Procedures” by Steven M. Bragg
“Financial Accounting: An Introduction to Concepts, Methods, and Uses” by Gary A. Porter

Real Estate Basics: Depreciation (Accounting) Fundamentals Quiz

### Does depreciation apply to both the building and the land it is on? - [ ] Yes, both the building and the land can be depreciated. - [x] No, only the building can be depreciated. - [ ] Depreciation does not apply to real estate at all. - [ ] Both the building and land depreciate equally. > **Explanation:** Depreciation only applies to the building itself and not the land it is located on. Land typically does not lose value over time, whereas buildings do due to wear and tear. ### Over how many years must residential property be depreciated according to tax laws? - [x] 27.5 years - [ ] 15 years - [ ] 30 years - [ ] 39 years > **Explanation:** According to tax laws, residential properties must be depreciated over a 27.5 year term. This allows for an annual deduction related to the depreciation. ### Over how many years must commercial property be depreciated according to tax laws? - [ ] 27.5 years - [ ] 30 years - [x] 39 years - [ ] 45 years > **Explanation:** According to tax laws, commercial properties must be depreciated over a 39-year term. This extended period helps distribute the depreciation deduction over a longer time frame. ### Which type of property allows for depreciation as an income tax deduction? - [ ] Personal-use property - [ ] Land - [x] Income-producing property - [ ] All types of property > **Explanation:** Depreciation can be used as an income tax deduction for businesses for properties that are used for income-producing activities. Properties used for personal purposes do not qualify for depreciation deductions. ### What must a property have for it to qualify for depreciation? - [x] A useful life of at least one year - [ ] A mortgage attached to it - [ ] An appraisal conducted every three years - [ ] Equal use between personal and business > **Explanation:** To qualify for depreciation, the property must have a continued useful life of at least one year and must be used for an income-producing activity. ### Who provides the allowance for the normal wear and tear of a piece of property? - [ ] Real estate agents - [ ] Local municipalities - [ ] Property management companies - [x] The Internal Revenue Service (IRS) > **Explanation:** The Internal Revenue Service (IRS) provides an allowance for the normal wear and tear of a piece of property, which can be deducted from taxable income through depreciation. ### When filing an annual tax report, who can claim depreciation? - [ ] Any resident of the United States - [ ] Any homeowner regardless of purpose - [x] Individuals or businesses that own income-producing property - [ ] Only those with newly built properties > **Explanation:** Only individuals or businesses that own income-producing property and meet other specified criteria can claim depreciation when filing an annual tax report with the IRS. ### Depreciation is used to offset which type of expense for businesses? - [x] Income tax liability - [ ] Mortgage interest - [ ] Utility expenses - [ ] Insurance premiums > **Explanation:** Depreciation can be used as an income tax deduction, effectively reducing the income tax liability of a business. ### Why is depreciation especially important for businesses? - [ ] It is a source of immediate revenue. - [ ] It increases the value of properties. - [x] It allows for a significant tax deduction over time. - [ ] It avoids the need for any property-related expenses. > **Explanation:** Depreciation is important for businesses as it allows for a significant tax deduction over time. This tax benefit can improve the financial condition of the business by reducing tax liabilities. ### What aspect of a property predominantly affects its depreciation schedule? - [x] Whether it is residential or commercial - [ ] The construction material used - [ ] The color of the building - [ ] The landscape quality > **Explanation:** The depreciation schedule is predominantly affected by whether the property is residential or commercial, with residential properties having a 27.5-year term and commercial properties having a 39-year term.