Do You Know the Most Common Types of Depreciation?

Depreciation expense is used in accounting to allocate the cost of a tangible asset over its useful life. In other words, it is the reduction of value in an asset over time due to usage, wear and tear, or obsolescence.  By depreciating an asset an investor can offset their income by the annual amount they depreciate the asset, thus increasing their “in pocket” cashflow.

Straight-line

Straight-line depreciation is a very common and simple method of calculating the expense. In straight-line depreciation, the expense amount is the same every year over the useful life of the asset.  Under new IRS guidelines, an investor can now depreciate an asset over a 25 year period.

Depreciation Expense = (Cost – Salvage value) / Useful life

Double declining balance

Compared to other depreciation methods, double-declining-balance results in larger expense in the earlier years as opposed to the later years of an asset’s useful life. The method reflects the fact that assets are more productive in its early years than in its later years. With the double-declining-balance method, the depreciation factor is 2x that of a straight line expense method.

Periodic Depreciation Expense = Beginning book value x Rate of depreciation

Units of production

This method provides for depreciation by means of a fixed rate per unit of production. Under this method, one must first determine the cost per one production unit and then multiply that cost per unit with the total number of units the company produced within an accounting period to determine its depreciation expense.

Depreciation Expense = Total Acquisition Cost - Salvage Value / Estimated Total Units

Sum of years digits

The sum-of-year depreciation method produces a variable depreciation expense. At the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straight-line depreciation.

Depreciation expense =  (total acquisition cost - salvage value)

Double-Declining-Balance Method

The DDB method simply doubles the straight-line depreciation amount that is taken in the first year, and then that same percentage is applied to the un-depreciated amount in subsequent years. This method produces a very aggressive depreciation schedule. The asset cannot be depreciated beyond its salvage value.

Depreciation expense= (total acquisition cost - accumulated depreciation) n = number of years

Many tax systems prescribe longer depreciable lives for buildings and land improvements. Such lives may vary by type of use. Many such systems, including the United States and Canada, permit depreciation for real property using only the straight line method, or a small fixed percentage of cost.  Another method to increase depreciation on a real estate asset is called cost segration, whereby a professional company comes out and segregates the costs and useful life of all of the components of a real estate building, ususally resulting in accelerated depreciation schedules.  

Remember though, generally no depreciation tax deduction is allowed for bare land. Regardless of what type of depreciation you decide to go with, please consult your C.P.A. or other tax professional to determine what is best for your goals.