I do NOT understand depreciation. Can somebody help me? I need it explained like a 5 year old.

[Kali]

I don't get it, I'm not ever going to get it and I don't even WANT to get it. But I have a question.

Isn't depreciation a DEDUCTION you take on your taxes? Someone I know is trying to tell me they are taking a business LOSS because of depreciation. Is that possible? I mean the shit is so confusing to me, but I thought when you figure depreciation it created an amount you DEDUCT from the income for the year. Am I totally wrong?

How could he say - and I quote: "depreciation was $XXXX" then claim the loss for the year was damn near that same amount, when by my plain old cash calculation the guy cleared almost that amount???

[The Straight Story]

1. This might be close:

You have a car worth 10k. Next year it is only worth $7k, so if you sell it (get a loan against/etc) you would have $3k less than last year.

Your net worth went down basically.

I am sure someone else will give a better explanation but that's a start I hope.

[HooptieWagon]

4. Yes, thats pretty much it. Furthermore...

if you used the car for some kind of business, lets say part time delivery service, and made $2500 in gross income; Ok, on your taxes you made 2500, but the car lost 3000 in value due to depreciation. So you have a net loss of $500.

[Kali]

9. ok but

in terms of actual money, you still made the 2500 right? so where is the monetary loss? you still have the damn car, and you made 2500.

and you get to deduct SOMETHING due to these silly calculations, right?

say your tax on the 2500 was 50 bucks if you didn't deal with the car and the accounting crap.

what would the effect of doing the accounting crap have on that $50 amount?

[The Straight Story]

11. Ok, let's see....try this

You buy the car for 10k and it would only lose 1k in value the first year.

But then you drive it around for business. You make cash, but lose value on the car (which you could have traded in/sold/etc for cash) because of the mileage/wear/tear/and you also had to pay for gas, oil, filters, etc. You had to spend money to make it so you can deduct that as an expense - one of the expenses is the loss of value (kind of like when your house value goes down you are unable to get as much as before so you lost something).

You made some 'money' and lost some.

[HooptieWagon]

14. Yes, you made cash, but you lost wealth.

[Kali]

17. and also avoided paying tax on that cash right?

[HooptieWagon]

19. Yes, because the wealth you lost was greater than the cash you made.

[HiPointDem]

42. But workers can't deduct the value of their "lost wealth" from their taxes, correct?

[HooptieWagon]

45. No. Depreciation is a deduction for businesses.

Intent is to stimulate investment in equipment. Individuals can deduct some work related expenses; tools, training, uniforms, by itemizing their deductions. But usually the itemized deductions end up being less than just taking the personal deduction. If a person owns an expensive item that loses value with age or incurs high maintainence or storage costs; boat, airplane, etc, then in many cases a business can be formed and taxes lowered. Best consult a CPA or tax expert for details. Individuals can deduct lost wealth in some cases by declaring a capital loss, for example if you sell real estate or stocks for less than you paid. But thats not considered depreciation.

[quaker bill]

18. I run an isolated total cash business

I have been doing so for 5 years now. I make jewelry, after my day job. I started with a simple set of hand tools that I bought for an apprenticeship in High School, and a stone cutting machine my parents bought me in middle school, all quite some time ago

Starting from that simple point, I have now sold many thousands of dollars of jewelry. A very large portion of the dollars I have made have been spent to equip a real 1940's style jewelers production studio. In short I have purchased a variety of hand operated equipment with the dollars. All of it has been bought to allow me to incorporate a greater range of techniques into my body of work and to allow me to recycle precious metal scrap into new pieces.

In 5 years, I have only paid myself only once ($500). Every other dime has gone into materials and equipment. The way I can expense out the investment of making the business fly entirely off of sweat equity, is to depreciate the equipment against sales. This way I get to claim that in fact I have only pocketed $500. Since depreciation is accelerated, I will expense out all the equipment in 3 to 5 years, after which profits will be taxed fully as the equipment will have been "paid for".

It would make more sense to me to be able to just deduct the full equipment cost from profit the year that I spend the money, but that is not how it is done.

[Kali]

22. that does make some actual sense to me, believe it or not!

in my example there sure isn't any reinvestment going on and I am positive the "loss" is just to off-set personal income tax from other endeavors.

it is legal, but there is some other stuff going on too. I wanted to make sure what was happening cash-wise, not just bookkeeping magic.

[Celebration]

33. if there is depreciation

there had to have been a capital investment at some point, in a building or whatever.

[Kali]

34. would an inheritance of a farm count? (or purchasing an existing business)

could that be the starting point for depreciating structures? That is about the only thing I can think of that really makes sense.

The buildings and other structures are old and falling apart but if the rules say the point that individual "placed them in service" is the point of acquisition then I suppose that might be what he is talking about.

And that would be approaching the 25 year mark - isn't that about the limit on buildings?

edit - miscalculation, it has been about 15 years so perhaps he has even more time to play these games.

[Celebration]

35. why don't you ask him?

It would depend on specifics that we don't know.

Like someone else said, maybe he is depreciating his herd. I have no idea what the rules are on cattle, etc.

But depreciation really isn't a racket, at least for the small business person. Everything taken in depreciation was a cash outlay that wasn't expensed before.

It can get more like a racket for the oil and gas people and other large industries with lobbying power.

[HooptieWagon]

46. I would think depreciation could be claimed on farm structures.

Probably not on the land itself. Although, if sold for less than was paid, a capital loss can be declared.

[Jamastiene]

31. Trust me. A car costs more as it depreciates.

As cars get older and wear out from lots of use, they cost more to run and maintain. You still lose money because of that, through the expenses it will take to keep the car running.

[sendero]

36. Welcome to the wonderful world of accounting.

.... and tax law, and yes many people do very well thank you playing games with these numbers.

[panader0]

2. It's the opposite of appreciation

As in :Jeannie used to appreciate me more, but it's depreciated.

[Kali]

10. makes a HELL of a lot more sense

than the 120 page IRS book I just skimmed through for the past 2 hours!

[coalition_unwilling]

51. Hah! Best explanation of depreciation EVER! Thanks - n/t

[quinnox]

3. a tax professional

could help you, sounds like a technical question about how to handle your taxes is what you want.

[freshwest]

5. No pro here, but I think it means what you got, isn't worth what you paid for it? Thus a loss and

You may need to replace it in order to continue doing business, thus more expense?

I have a CPA friend but she's out of town, so I can't get you the correct answer. But that's what I think.

[Celebration]

6. suppose you have a piece of equipment

And you paid 10,000 for it in year one. It lasts five years, though, so even though you spent the money in year one, you can't take a 10,000 deduction for it in year one. You have to spread the deduction over five years. That would make the deduction for each of the five years 2,000.

So with your friend--Say in year nine he cleared, in cash 1800 dollars. He still gets the depreciation deduction (remember he SPENT the cash in year one, but only gets to deduct it over five years). His cash flow for the year is 1800, but for tax purposes he loses two hundred dollars that year.

Comprende?

[Kali]

12. no

I just don't see it. I think you meant he takes his last deduction at year five and the "nine" in your example is supposed to be a "five" as well (but I am not sure because this crap is so confusing!)

if that is just a typo, I still don't get it. He cleared 1800, and he gets to deduct 2000. but that 200 he "loses" doesn't really exist anywhere, right? (except on paper from five years before)

so if my guy has been deducting something like 25K in depreciation (and that seems insane to me) and this year cleared 10K before taxes - he can only zero that out right? so he would have no tax liability. But in reality he keeps the full 10K, yes? (I don't care what he spent 10 or 25 years ago - except that I know it wasn't anything near any of this - I just want to know what happens to the cash from this year.

[Celebration]

32. yes year four

Sorry about that!

Just keep in mind that cash flow is something completely different from earnings.

[longship]

26. This is a pretty good description

It can get much more complicated, as the rules have been tweaked significantly.

The general idea is that a company builds, say a building on a property. The property's value isn't going to change. But the capital investment of the building is subject to a diminished value as it ages. There are all sorts of esoteric IRS rules for coming up with the lifetime of the "asset". The bottom line is that your capital investment in building on the property can be deducted from your income, but only to the extent of its current value, which putatively decreases with age.

The IRS has very specific rules for a variety of classes of such "capitalized" property. E. G., computer equipment for years is entirely deductible, 100% depreciation, for many years. But buildings have a long lifetime, so it would be incorrect to allow a company to deduct the cost of construction of the building, since it would have substantial value even if the company went broke. (Possibly except if the building was in Detroit, but that's another problem.)

I hope this helps.

[Cleita]

7. It's value lost gradually on an item purchased for a business or even personal stuff.

For instance, take a piece of equipment in a restaurant like meat slicer. You figure out how long the item is going to last before it implodes or become outdated. You take the cost of the item and divide that by the number of years you decided it would lose value each year until you reach 0. This is the easiest way although there are other ways of figuring it. Since the depreciation is an expense you can put it on your Income and Expense statement each year for tax reasons. You also reduce the value of the meat slicer on the books each time you take depreciation. It's kind of a false figure though. Because equipment can last longer than expected or can go up in value sometimes, or become obsolete when not expected to. However, you have to use the original figure for accounting purposes in depreciated value until you sell it. Then the worth of the asset on the books may not necessarily match what you get in a sale.

[enough]

8. Depreciation is one of the factors reported on Schedule C (profit or loss from business).

Because of the way the tax law is structured, it's perfectly possible for a business to show a loss "due to" depreciation. But you can't just name a figure at stick it into the line for depreciation. You have to have documentation showing that the depreciation is "real" according to the tax code. And assuming the IRS looks into it, it has to be "legitimate."

This is not to be confused with a "deduction" taken by an individual on his or her income tax.

Not saying it's fair or right, but that's the way the law is written.

[Kali]

15. or in this case schedule F

and the only possibility for that valuable of an asset has to be the livestock but in terms of the business actually costing the guy the "loss" showing on the income from the enterprise, it is just so much BS, right?

[csziggy]

21. It's all a tax dodge but it is how it's done

In my case for the farm, say I put $10,000 in new fencing. That fence will last 10 years (arbitrary number for illustration only - there are tables for different kinds of equipment and facilities). Instead of writing off the entire cost of the fence the first year as an expense, it depreciates $1000 per year over the ten year expected lifetime.

Another way to look at it is that when you invest in equipment or livestock, it loses value over time. If I buy a herd of young cows, they will not be worth as much in five years when they are older. So the original investment value of the herd is reduced over time as depreciation. The offspring of the cows are handled differently in the tax code - unless I keep the heifers to replace their aging mothers. Then the heifers can be depreciated as they age.

Investors can write off investment losses over a number of years by carrying losses forward and using them to write off future income. Depreciation lets regular businesses write off major investments in equipment against future income. Same deal.

[Kali]

24. I think I get it now

and yes I bet this is being done with raised heifers/cows - because there sure as hell hasn't been any real investment or improvements done in forfreakingever!

[HooptieWagon]

48. He is also probably getting a lower property tax

by running a "farm". And there may be other federal tax breaks or subsidies for agriculture that arent available to other small businesses. Save the family farm and all that.

[Larry Ogg]

13. If you had a business and bought a brand new company car worth $30,000.00

Lets say your business had enough money to pay cash from the business bank account.

Money in the bank is an asset, so when you bought the company car you exchanged a $30,000.00 cash asset, for a $30,000.00 car asset, witch has the same value as the cash asset.

But lets say the car has a life expectancy of 10 years, you would then divide the $30,000.00 value of the car by 10 years, witch is $3,000.00 a year...

So in a year the car will depreciate by $3,000.00 this is what you can claim on your taxes as a depreciation expense.

The car asset value after a years depreciation is now worth $27.000.00 witch is the same as $27,000.00 cash.

Do this for ten years until the asset value is $00.00

You can also use mileage as a means to depreciate the asset.

You can also borrow the $30,000.00 to purchase the asset, and then you will have $30,000.00 debt as well as a $30,000.00 asset that you would depreciate the same as if you paid cash for it.

[Yo_Mama]

16. In terms of business taxes, here's how it works

First, depreciation is used when the cost of something is not deductible during the tax year that it is purchased.

In other words, suppose you have a business that buys product X for use in their business. Product X costs them 100,000. After a certain period of time, Product X will no longer be worth anything - it will have been worn out.

The tax rules do not allow the cost of product X to be deducted from the profits in the year of purchase. Instead, the rules say that the cost of the product will be deducted over 5 years. So each year 1/5th of the cost of product X is deducted from profits, which yields a deduction of $20,000 a year.

In year 4, profits not including the deduction were $25,000. After the deduction, the company reports $5,000 in profits. This is the reason cash flow is not the same as taxable profits.

Here's the difference between cash flow and taxable profits with depreciation, assuming that this company has very stable profits from ongoing sales/service of $25,000 a year:
Year 1:
Bought Product X for use in business for $100,000, earned $25,000 on sales:
Cash flow: -$75,000
Reported Profits: $5,000
Year 2:
Cash flow: $25,000
Profits: $5,000
Year 3:
Cash flow: $25,000
Profits: $5,000
Year 4:
Cash flow: $25,000
Profits: $5,000
Year 5:
Cash flow: $25,000
Profits: $5,000
Assuming that Product X is still usable in Year 6:
Year 6:
Cash flow: $25,000
Profits: $25,000

Some things a business buys are deducted during the year of purchase (if they have been consumed or expended) but generally, durable products (a car, a truck, a piece of machinery, buildings) all have specified depreciation schedules.

[Drew Richards]

20. Maybe this will help...sometimes I am not real clear though...

Let me see if i can take a stab at it for you.

In a sentence...

A net worth loss to the value of your company due to depreciation ONLY applies if you are a publicly traded company OR if you are SELLING the company and all its assets.

Say you are mining company that is traded on the stock market. (if you are not a public traded company then there is no financial loss from depreciation it is balanced by tax write offs)

Because you are a public company your net worth value is calculated by your production (corporate Net Gains) AND by your inventory which depreciates in value every year.

Because of depreciation on all your heavy equipment there is a direct valuation depreciation on the net worth of your company...But this is virtually written off by two things...

1. the Equipment depreciation tax write off.
2. Tax write off on corporate net loss and depreciation which a LLC SC LC can write off totally for 5 years and partially there after.

This is actually miniscule I mean tiny tiny unless you're an idiot and have no clue how to run a business.

ZEROTH RULE OF BUSINESS.

1. INCORPORATE BEFORE you begin...LLC (limited liability corporation) SC LC to limit you financial libility.

*FIRST RULE OF BUSINESS*.

2. Expect to run in the red for the first 5 years and have the liquid capital to survive those first 5 years while building your business clientel or product to the point of break even.

3. At the 5 year (hopefully) break even point you reinvest capital gains to maximize production for the next two years, and eat or push forward to the next couple years the small depreciation loss.

4. At year 7 you should be a viable company that can write off the devaluation percentage as business and purchase or acquire newer more efficient equipment or personnel to maximize your profitability through new clientel or production.

5. At year 8 you Crush your employees, see them driven before you, to hear the lamentation of their women. (Conan)

[customerserviceguy]

23. I haven't done taxes professionally for about twenty years, but here goes

When you buy things that are used to produce income in either an investment or a business situation (not like work clothes for your job, for example) you get to subtract what you paid for those things from the income you get from them. Some things have really short useful lives, or are pretty insignificant, like envelopes and paper for the bills you send out in a business. Some things you have to deduct from the proceeds of the eventual sale, but not before then, like the price you pay for some shares of stock.

Many things that one buys for business or investment have a really long useful life. Unless there is a tax break allowing you to deduct their value in the year of purchase (happens for business property, but generally not for investment property) you have to spread the cost of the item over a useful life. Tax rules often specify this life, and just how fast you can take those deductions against the income from the activity they're used in. Sometimes, as in the case of a newly started business, or a rental residential property, the non-depreciation expenses exceed the income from the activity. Depreciation often leads to an increase in the loss, or the wiping out of a tiny profit from the activity, and you get to deduct the resulting loss against other income that you have coming in.

This often happens with rental real estate. In the early years, rents don't cover mortgage interest, taxes, and maintenance, and you get to "recover" a portion of the building's purchase price through depreciation deductions. These shield income from your wages or your profitable investments, by offsetting the loss against the income from those gainful activities. In "normal" markets, real estate doesn't really go down in value, and when you finally sell the building, you have to "recapture" the deductions you took for depreciation that didn't really occur. One of the great tax breaks is that while you were using that depreciation to offset regular income dollar-for-dollar, when you recapture, you get to use favorable capital gains tax rates on the "recaptured" gain, at least to the extent that it corresponds to straight-line depreciation (that which would be taken evenly over a period of years) versus any accelerated depreciation (that which is taken over what would be allowed as straight-line depreciation).

Eventually, you pay taxes on the amounts you deducted in earlier years, but those taxes are deferred, and the capital gains tax break makes it even sweeter. Let's say you lend me $100, and I have to pay you that $100 ten years from now, no interest. I win. Well, if I have to pay you only $25-$40 dollars ten years later, hey, I really win!

It makes real estate a great investment in good times. Lately, it's not that good.

[Kali]

25. I am pretty sure the only assets to be depreciated in this situation are heifers kept to replace old

cows, and trust me there is not much $$ going into them either. He sure as hell isn't buying replacement heifers. This has been really enlightening to finally kind of work out in my mind what is going on. Thanks to everybody who replied.

Even the discussion about real investment in equipment and such has been helpful (I have gone through the figuring process for vehicles but really didn't know WTF I was doing)

[TreasonousBastard]

27. After all the technical explanations, what you want to know is...

there are two kinds of depreciation.

In the real world, you own something that gets old and is worth less year after year. Like a car. Some things, like real estate and Picasso paintings get old, but are worth more. Things that are worth less depreciate, and things that are worth more appreciate. Simple, eh?

Well, in the accounting world, this is all ignored and they make stuff up in order to figure out what you really own and get tax breaks. A rental building you might own depreciates on your books and gives you a tax deduction but often actually appreciates in value if you want to sell it and someone has to figure out just how to account for all this on your books. This is why you pay your accountant so much money-- he understands that marvelous work of fiction known as Generally Accepted Accounting Principles.

[Kali]

30. oh you nailed it

I learned this stuff 20 years ago - I was on the jury for Charlie Keating's civil trial in Tucson. OMG the paper world of accounting. It was fascinating stuff, but so foreign to my life!

[taught_me_patience]

38. If you sell the rental, the gain is calculated on the depreciated value

And you pay taxes on a larger capital gain. So, in reality, all you are doing is delaying the taxes... not that big of an advantage.

[coalition_unwilling]

52. Hah! LOL - n/t

[Egalitarian Thug]

28. Let me cut to the chase, It is a taxpayer supported subsidy to businesses

that ordinary people are not allowed.

In theory, it is a way to account for the diminishing value of durable equipment and some other properties. When equipment is bought it has a value, X. Over time that equipment becomes less valuable until, eventually it has no value at all. So, if that time is determined to be 10 years (from full value to none), a business is allowed to deduct that loss of value over that time period, so; In year 1 the value of X is 1. In year 2 the value is .9. In year 3 the value is .81, and so on..

This is oversimplified but, I hope, that helps.

The U.S. tax code is completely bizarre. It is so large that literally no one knows it, and therefore, it is reduced to a matter of opinion, even in the IRS. If you are rich, you can afford to buy opinions that favor you, if you're not you have to submit to the IRS' opinion. This is how GE pays no tax on billions of profit and you pay far more than you should, even if you don't make money.

[customerserviceguy]

40. It recognizes the difference between things bought for investment and things bought for consumption

The "ordinary" people you allude to spend most of their money on consumption. When they actually invest in something, they get to consider its cost basis in calculating profit and loss, and the tax code reflects that, too. In fact, the investment in a principal personal residence is one of the most tax-favored investments under the entire tax code. Not only do you get to shield up to $250K of profit every two years (double that for a married couple) you also get to deduct from taxable income the real estate taxes and mortgage interest which finance it.

Now, there are plenty of "consumption" expenses that are at least partially allowable to businesses (travel and entertainment being chief among them), but the tax code is more often than not set up to recognize deductions for legitimate expenses incurred in producing income for the most part.

There's a basic fairness in that. Let's say that you have two people, an author who brings in $1 million from writing books, and a business owner who grosses the same million from his/her activities. The author would have very minimal expenses in producing that million, but if the business owner spends $900 K on goods for resale and wages for employees, isn't it fair to tax the latter on only the $100 K realized?

[Egalitarian Thug]

41. Even your hypothetical cannot make an honest comparison to support your opinion.

The housing interest deduction is the sole remaining sop left to the suckers that are required to support this whole scam, while business enjoys a wide range of benefits that amount to taxpayer subsidies.

I'm more than happy to debate the issue with you in as much detail as you like, but this diary is a query about what depreciation is.

[HiPointDem]

43. I have to have a car to get to my job. Why can't I deduct depreciation on the car as a business

expense?

[HooptieWagon]

47. Transportation to and from work cant be expensed

Since technically you arent working. If you have transportation expenses while working; truck driver, pizza delivery, real estate agent, etc, then yes you can deduct the percentage of expenses incurred while working. Usually, its done by mileage.

[customerserviceguy]

50. In the tax code I'd design, you would

You'd be allowed to deduct all work clothes, not just uniforms and protective clothing. I used to be a tax accountant, and I know full well the disparities between what employees and the self-employed get to write off. When we're talking about closing tax loopholes, I firmly believe that is where you have to go.

[dems_rightnow]

44. No it is not

Even the theory is wrong.

Depreciation is a negative for business, not a subsidy. If I buy a piece of equipment for $10,000, I am out $10,000. But the government says "You may not deduct that $10,000 this year, you must spread it over time".

And the theory is not to account for diminishing value at all. It's to spread the cost of the equipment over the period that it benefits the business. Nothing to do with diminishing value.

[lumberjack_jeff]

29. Lumberjack Jeff, LLC, bought a log truck.

It cost the company $100,000. Since the company only made $40,000 from the operation of that truck, the company had a one-year loss of -$60,000.

But wait, the truck is still worth something at the end of the year, right? It's not fair to uncle sam to write off the whole value of a capital asset against taxes in one year if I still have most of that investment at the end of the year.

Conceptually, the truck probably has a useful life of about 10 years, so straight line depreciation allows LJLLC to write off 10,000 each year, leaving a taxable income of $30,000 for the year.

Depreciation is a deduction because it IS a loss. If LJLLC hadn't bought that truck, they wouldn't have lost that 10% of the value of their investment.

[taught_me_patience]

37. You can have a loss resulting from normal depreciation schedule

but cannot use "accelerated depreciation" to create a loss.

Why do you depreciate over time? In accounting you want to try to match the expenses to when revenue occurs.

http://en.wikipedia.org/wiki/Matching_principle

[trackfan]

39. In accrual accounting depreciation is an expense.

Say you buy a car for your business for $10,000. That is not counted as an expense, but as a capital asset. The $10,000 in cash that you put out = the $10,000 asset (car), so there has been no net change to the amount of "stuff" (capital) your business owns. Each year the car decreases in value, and the amount of that decrease is the depreciation expense.

Think of expense in terms of "expending". When the car is new, and whole, you've "expent" nothing of its value. Time decreases the value of the car, and as it does so, you account for this "expense" of value in dollars.

[ctaylors6]

49. also: it's timing issue, matching revenue with expense

Say someone has a business making specialized bedding by hand. Their costs are the fabric, thread, and other materials PLUS what the business pays the people who sew the bedding. The business's profit is (1) the amount for which they sell the bedding LESS (2) the costs for materials and labor. For all the bedding they made and sold in 2011, it's easy to calculate their revenue and their expenses for 2011.

Now picture a different kind of sewing business that invests in equipment that machine sews more standard, not specialized, bedding. That machinery is made to last 10 years. If the company makes about the same number of comforters each of those 10 years, their revenue will be pretty evenly spread out over the 10 years. Straight line, simple depreciation would take the total cost of the equipment, divide by 10, and the business would expense that 1/10 amount each of the 10 years.

Assume for simplicity that the business had saved the money to buy the equipment for $100,000. The company's revenue is $12,000 per year. In year 1, without depreciation, the company would have a massive loss: $12,000 revenue - $100,000 expense. Each year after that, it would have $12,000 revenue and no expense for the equipment.

With depreciation, each year the company would have $12,000 revenue less $10,000 expense for machine, for profit of $2,000. (Of course, I'm ignoring other expenses.)

needless to say, the US tax code depreciation sections are way, way more complicated than that. There's accelerated depreciation, where the total cost is depreciated more in earlier years to better reflect the theory that as equipment ages it doesn't work as well and therefore does not produce as much. And many other rules.

Hope that helps though with a basic of depreciation!