A client recently asked me “What exactly is depreciation?” I suspect that depreciation is a misunderstood concept by many non-accountants. Not being an accountant, I had only a vague understanding of depreciation until one night in business school when I finally saw the light. I would like to present here a brief depreciation. The concepts are the same regardless of the type of asset in question, but here we will focus on real estate…
Generally speaking, an old asset is worth less than a new asset. Why? Because things wear out. As an example, I’ll use my first car, a modern Plymouth Volare inherited from my grandfather. When the Volare was a new car, it was worth 100% of its purchase price. When I got it many thousands of miles later, it was worth a little less than that. And then when I passed it on to my brother, who passed it on to a cousin, who abandoned it somewhere in the swamps of New Jersey… well, it wasn’t worth much at the time.
In accounting, when an asset is first purchased, it is placed on the balance sheet at its full purchase price. ‘Depreciation’ is the means by which you continually adjust the asset’s value downwards so that the asset’s book value more closely reflects reality. Uncle Sam is happy to lend a hand, decreeing the rate at which you are allowed to depreciate a given item. Why should Uncle Sam care? Because every time you depreciate an asset, the write-off of its value goes to your income statement as an expense, reducing your income and therefore reducing your tax burden. Therefore, it is in your interest to depreciate as quickly as possible, while it is in the IRS’s interest to make the depreciation as slow as possible.
It is important to remember that depreciation is entirely a “paper” transaction rather than a “real” transaction. No cash changes hands. For this reason, depreciation cannot affect cash flow. That’s why when you look at a cash flow statement, you’ll see that depreciation is added back to net income (depreciation was deducted from income on the income statement, so it needs to be added back to the cash flow statement). cash).
In the case of real estate, it gets a bit more complicated. When you buy a building, you typically buy both the building and the land it sits on. Buildings wear down, but the land doesn’t. As a result, you can only depreciate the part of the purchase price that can be attributed to the building. Where is he supposed to get that number? … the appraisal of the property, where the building/property division will be included.
Once you know the value of the building, you can apply the IRS building depreciation schedule. Unfortunately, the property will not depreciate and will remain on your books at full value until you sell it.
Hope this helps you understand depreciation better!