What is depreciation?

By | February 13, 2008

depreciating equipmentAs tax season starts to ramp up, it’s an opportune time to delve into the topic of depreciation. It’s a term that’s often misunderstood, or not understood at all, somewhat like when your auto mechanic launches into a technical explanation of why your car is making that strange noise, and you find yourself nodding in feigned understanding while secretly wondering if your car even has a ‘smeelie bar.’

In essence, depreciation refers to the deduction you can claim on a piece of equipment over its lifespan. This is typically applied to equipment that will gradually break down and eventually have little to no value, like machinery, computers, and so forth.

Depreciation is permitted by the government because the alternatives aren’t particularly enticing. The first alternative is to not allow any deduction at all. If this were the case, there would be little incentive for businesses to invest in themselves.

The second alternative is to allow the entire cost of the equipment to be deducted. While this might seem like a good idea at first glance, it could result in businesses that invest heavily in equipment paying no taxes at all. As you might imagine, the government isn’t overly keen on this idea, although as we’ve discussed in a previous post, there are certain exceptions to this rule.

So, we’re left with depreciation as the most viable alternative. Here’s a simple example to illustrate how it works:

Imagine you purchase a machine for $100,000. The government estimates that the machine has a ‘reasonable life’ of five years, so they allow you to deduct $20,000 per year over that five-year period.

This principle applies to most types of equipment, and essentially any asset a business uses that will eventually need to be replaced can be depreciated. This includes office machines, delivery fleets, buildings, and so on.

Of course, like any tax-related issue, there are numerous exceptions and intricacies to consider, but the above provides a general overview of how depreciation works. There’s one final point to mention: because the government assumes the item will depreciate to zero value, they’ll recoup some of the claimed depreciation by taxing you at a higher rate on any profits you make from the sale of the item. The rate varies depending on the asset, and with the ever-changing tax code, it’s crucial to consult with your accountant about this.

With tax season in full swing, I hope this primer on depreciation has shed some light on a complex but important aspect of your financial planning. As always, knowledge is power, and understanding the nuances of depreciation can help you make smarter business decisions.