What Is the Best Commercial Real Estate Investment? - Investopedia
When assessing a potential investment in commercial real estate, you should consider the best- and worst-case scenarios for the property. Is it ...
depreciation
There are many tax implications associated with commercial real estate investments. In the United States, commercial properties typically undergo <anchor>depreciation</anchor> over a longer span (39 years) than residential properties (27.5 years). This results in smaller annual tax deductions for commercial than residential properties. Selling commercial property would likely mean paying capital gains tax in the year when the property is sold.
Depreciation: Definition and Types, With Calculation Examples
- SearchSearch

Please fill out this field.

SearchSearch

Please fill out this field.

Investing

Simulator

Banking

Personal Finance

Economy

News

Reviews

Follow Us

Table of Contents

Expand

Table of Contents

# Depreciation: Definition and Types, With Calculation Examples

Updated July 29, 2024

Reviewed by

Reviewed byEbony Howard

Ebony Howard is a certified public accountant and a QuickBooks ProAdvisor tax expert. She has been in the accounting, audit, and tax profession for more than 13 years, working with individuals and a variety of companies in the health care, banking, and accounting industries.

Part of the Series

The Evolution of Accounting and Accounting Terminology

Terms A-B

Terms C

Terms D-E

Terms F-M

Terms N-O

Terms P-S

Terms T-Z

## What Is Depreciation?

Depreciation is an accounting practice used to spread the cost of a tangible or physical asset, such as a piece of machinery or a fleet of cars, over its useful life. The amount an asset is depreciated in a given period of time is a representation of how much of that asset's value has been used up.

Companies depreciate assets for both tax and accounting purposes. There are several different depreciation methods, including straight-line depreciation and accelerated depreciation.

### Key Takeaways

- Depreciation allows businesses to spread the cost of physical assets—for example, a piece of machinery or a fleet of cars—over a period of years for accounting and tax purposes.
- The amount that an asset has depreciated in a given period of time is a representation of how much of that asset's value has been used up.
- There are several different depreciation methods, including straight-line depreciation and accelerated depreciation.

Investopedia / Jessica Olah

## Depreciation Overview

Machinery and equipment are expensive assets for a company to purchase. Instead of realizing the entire cost of an asset in the year it is purchased, companies can use depreciation to spread out the cost of an asset for accounting purposes over a period of years (equal to the asset's useful life). This allows the company to match depreciation expenses to related revenues in the same reporting period—and write off an asset's value over a period of time for tax purposes.

When using depreciation, companies can move the cost of an asset from their balance sheets to their income statements. When a company buys an asset, it records the transaction on its balance sheet as a debit (this increases the asset account on the balance sheet) and a credit; this reduces cash (or increases accounts payable) on its balance sheet. Neither of these entries affects the income statement, where revenues and expenses are reported.

Then, at the end of an accounting period, a company using depreciation will book depreciation for all its capitalized assets that are not yet fully depreciated. These accounting entries will consist of the following:

- Debit to depreciation expense, which flows through to the income statement
- Credit to accumulated depreciation, which is reported on the balance sheet

## Depreciation and Taxes

Businesses also use depreciation for tax purposes—namely, to reduce their total taxable income and, thus, reduce their tax liability. Under U.S. tax law, a business can take a deduction for the cost of an asset, thereby reducing their taxable income. But, in most cases, the cost of the asset must be spread out over time; this is called asset depreciation. (In some instances, a business can take the entire deduction in the first year, under Section 179 of the tax code.) The IRS also has requirements for the types of assets that qualify.

Buildings and structures can be depreciated, but land is not eligible for depreciation.

## Depreciation in Accounting

If an asset is depreciated for financial reporting purposes, it's considered a non-cash charge because it doesn't represent an actual cash outflow. While the entire cash outlay might be paid initially—at the time an asset is purchased—the expense is recorded incrementally (to reflect that an asset provides a benefit to a company over an extended period of time). And, the depreciation charges still reduce a company's earnings, which is helpful for tax purposes.

All U.S. companies are expected to adhere to the generally accepted accounting principles (GAAP)—a set of accounting standards issued by the Financial Accounting Standards Board (FASB)—when using deprecation. Under GAAP, the matching principle (an accrual accounting principle) dictates that expenses must be matched to the same period in which the related revenue is generated; in accounting, depreciation helps to tie the cost of an asset with the benefit of its use over time. The practice of depreciation helps a company capture the incremental expense associated with the using up of an asset every year it is used (and thus, generates revenue).

The total amount depreciated each year, which is represented as a percentage, is called the depreciation rate. For example, if a company has $100,000 in total depreciation over an asset's expected life, and the annual depreciation is $15,000, the depreciation rate would be 15% per year.

### Threshold Amounts

Different companies may set their own threshold amounts to determine when to depreciate an asset and when to simply expense it in its first year of service. For example, a small company might set a $500 threshold; any asset purchased for $500 or greater will be depreciated and any asset under $500 will be expensed in the year it is purchased. On the other hand, a larger company might set a $10,000 threshold;

### Accumulated Depreciation, Carrying Value, and Salvage Value

Accumulated depreciation is a contra-asset account on a balance sheet; its natural balance is a credit that reduces the overall value of a company's assets. Accumulated depreciation on any given asset is its cumulative depreciation up to a single point in its life.

Carrying value is the net of the asset account and the accumulated depreciation. Salvage value is the carrying value that remains on the balance sheet after which all depreciation is accounted for until the asset is disposed of or sold. Salvage value is what a company expects to receive in exchange for the asset at the end of its useful life.

The IRS publishes depreciation schedules indicating the total number of years an asset can be depreciated for tax purposes, depending on the type of asset.

## Types of Depreciation With Calculation Examples

There are a number of methods that accountants can use to depreciate assets. These methods are: straight-line, declining balance, double-declining balance, sum-of-the-years' digits, and unit of production.

### Straight-Line Method

Straight Line Depreciation.
Image by Theresa Chiechi © The Balance 2019

For example, assume that a company buys a machine for $5,000. The company decides that the machine has a useful life of five years and a salvage value of $1,000. Based on these assumptions, the depreciable amount is $4,000 ($5,000 Cost – $1,000 Salvage Value = $4,000 Total Depreciation Amount).

The annual depreciation amount using the straight-line method is calculated by dividing the total depreciable amount by the total number of years of an asset's useful life. In this case, it comes to $800 per year ($4,000 Total Depreciation / 5 Years Useful Life = $800 Annual Depreciation). This results in an annual depreciation rate of 20% ($800 / $4,000).

### Declining Balance

The declining balance method is an accelerated depreciation method that begins with the asset's book value instead of its salvage value. Because an asset's carrying value is higher in earlier years (before the appreciation accelerates in later years), the same percentage causes a larger depreciation expense amount in earlier years, then declines each year thereafter. This is the formula:

Using the straight-line example above, the machine costs $5,000 and has a useful life of five years. In year one, depreciation would be $1,000 ($5,000 x (1 / 5) =$1,000).

In year two it would be ($5,000 - $1,000) x (1 / 5), or $800. In year three, ($5,000 - $1,000 - $800) x (1 / 5), or $640, and so forth.

### Double-Declining Balance (DDB)

The double-declining balance (DDB) method is an even more accelerated depreciation method. It doubles the (1 / Useful Life) multiplier, which makes it twice as fast as the declining balance method.

Continuing to use our example of a $5,000 machine, depreciation in year one would be $5,000 x (2 / 5), or $2,000. In year two it would be ($5,000 - $2,000) x (2 / 5), or $1,200, and so on.

Note that while salvage value is not used in declining balance calculations, once an asset has been depreciated down to its salvage value, it cannot be further depreciated.

### Sum-of-the-Years' Digits (SYD)

The sum-of-the-years' digits (SYD) method also allows for accelerated depreciation. You start by combining all the digits of the expected life of the asset.

For example, an asset with a five-year life would have a base of the sum of the digits one through five (or 1 + 2 + 3 + 4 + 5 = 15). In the first year, 5/15 of the depreciable base would be depreciated. In the second year, 4/15 of the depreciable base would be depreciated. This continues until year five, when the remaining 1/15 of the base is depreciated. The depreciable base in all of these cases is the purchase price minus the salvage value (or $4,000 in the example above).

For example, year one depreciation would be $1,333 ($4,000 x (5 / 15) = $1,333). In year two, it would be $1,067 ($4,000 x (4 / 15) = $1,067).

### Units of Production

This method, which is often used in manufacturing, requires an estimate of the total units an asset will produce over its useful life. Depreciation expense is then calculated per year based on the number of units produced that year. This method also calculates depreciation expenses using the depreciable base: purchase price minus salvage value.

## Why Are Assets Depreciated Over Time?

New assets are typically more valuable than older ones for a number of reasons. Depreciation measures the value an asset loses over time—directly from ongoing use (through wear and tear) and indirectly from the introduction of new product models (plus factors such as inflation). Writing off only a portion of the cost each year, rather than all at once, also allows businesses to report higher net income in the year of purchase than they would otherwise.

## How Do Businesses Determine Salvage Value?

Salvage value can be based on past history of similar assets, a professional appraisal, or a percentage estimate of the value of the asset at the end of its useful life.

## What Is Depreciation Recapture?

Depreciation recapture is a provision of the tax law that requires businesses or individuals that make a profit in selling an asset—that was previously depreciated—to report it as income. In effect, the amount of money they claimed in depreciation is subtracted from the cost basis they use to determine their gain in the transaction. Recapture can be common in real estate transactions where a property that has been depreciated for tax purposes, such as an apartment building, has gained value over time.

## How Does Depreciation Differ From Amortization?

Depreciation refers only to physical assets or property. Amortization depreciates intangible assets, such as intellectual property—including trademarks or patents—over time.

## The Bottom Line

Depreciation allows businesses to spread the cost of physical assets over a period of time, which has advantages from both an accounting and tax perspective. Businesses have a variety of depreciation methods to choose from, including straight-line, declining balance, double-declining balance, sum-of-the-years' digits, and unit of production .

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our
editorial policy.

Part of the Series

The Evolution of Accounting and Accounting Terminology

Terms A-B

Terms C

Terms D-E

Terms F-M

Terms N-O

Terms P-S

Terms T-Z

Open a New Bank Account

Advertiser Disclosure

×

The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.

Related Terms

EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternative measure of a company's overall financial performance.

Gross working capital is the sum of a company's current assets, which are convertible to cash and used to fund daily business activity.

Activity cost drivers give a more accurate determination of the true cost of business activity by considering the indirect expenses.

Earnings management is the use of accounting techniques to make a company’s financial reports look better.

Suspense accounts are used by businesses, mortgage servicers, and brokerage firms to temporarily account for customers' money, pending further action.

Creative accounting follows required laws and regulations, but capitalizes on loopholes to falsely portray a better financial image of a company.

Related Articles

Partner Links