What is Depreciation?
Have you asked yourself, "What is depreciation?" If so, you have come to the right place. Depreciation is defined as a reduction in the value of an asset with the passage of time, typically due to wear and tear. An asset can also decrease in value if there are unfavorable market conditions.
In general, some assets are more likely to depreciate than others. Currency and real estate are two examples of assets that have a tendency to lose value. For example, during the recent housing crisis in the United States, homeowners in some of the hardest-hit areas saw the value of their homes depreciate by as much as 50%. As you can imagine, significant depreciation can make it incredibly difficult to sell your home for a profit, because it will be worth much less than the purchase price.
Cars are another example of an asset that depreciates over time. You've probably heard people talk about the fact that your vehicle loses value as soon as you drive it off the lot. It's disheartening, but it's true - most cars do not get better with age. Rare or classic cars are one exception to the rule, but almost every other vehicle will be worth less and less money over time. In general, cars depreciate due to market conditions, resale value, age, wear and tear, etc. Unfortunately, there's nothing you can do when it comes to vehicle depreciation, because it's an inevitable side effect of owning a car.
Tax and Accounting
Depreciation is also an important term to understand when it comes to tax and accounting purposes. In terms of accounting, depreciation indicates how much of an asset's value has already been used. A business can deduct the cost of the tangible asset if purchased as a business expense, but when and how the deduction is taken depends on the asset and how long it will last. Businesses must depreciate specific assets in accordance with IRS requirements.
Business assets that can be depreciated include:
- Technology and computers
- Office furniture
- Business vehicles
- Physical buildings and improvements to buildings
Personal Asset Depreciation
Depreciation in relation to business assets is used to recognize the change in value of these assets over time. A business can reduce its amount of taxable income by including a specific amount of an asset as an expense. For example, if a business purchases office furniture for $50,000 and the furniture has a useful life of 10 years, the $50,000 will be divided over the 10 years of life. In other words, $5,000 can be deducted on the business's tax return for each of the 10 years. In turn, the annual $5,000 deduction will lower the business's taxable income.
In the end, whether you're talking about the assets of a business or a personal asset, depreciation reduces the value of those assets over time. A reduction in value can be unfortunate when you want to sell your car or piece of property, but at the same time, depreciation can benefit a business by reducing its taxable income. In other words, individuals do not typically benefit from the wear and tear or deterioration of an asset, but businesses will receive an annual allowance from the federal government via the IRS.