What excatly does depreciation mean?
I’ll give it a stab (but you folks with the greater knowledge base please jump in!):
- A decrease or loss in value, as because of age, wear, or market conditions.
- Accounting. An allowance made for a loss in value of property.
In real estate terms, the IRS allows you to write off (‘depreciate’) the value of “property used in a trade or business or in an income producing activity” over a given numer of years. Land CANNOT be depreciated. Generally, investment property (houses, duplexes, etc.) can be ‘written off’ over the course of 27-1/2 years.
Example: You purchase a property for $140K. Of this, $30K is assessed for the land (and cannot be depreciated) and $110K is assessed to the structure. If you divide this $110K over the 27-1/2 years, you can deduct $4,000 per year in depreiation off of your taxes (if you meet certain IRS guidelines).
Other ‘durable’ type items (stove, refrig, other appliances, carpet, drapes, etc.) can be depriciated over the course of 7 years.
IRS Pulication 946 deals with this issue in depth
http://www.irs.gov/publications/p946/ch01.html#d0e1667
The drawback, of course (hey, it’s the IRS – you knew there would be a drawback!), is that all depreciation claimed must be ‘recaptured’ when the property is sold.
You walk into a car dealership and find something nice for $40,000. You buy it. You get in and start it up, then drive to the exit and slowly ease it into traffic. The car is now worth $30,000.
I’m not much of a REI but i’m grateful to others that post information here so i’ll try to give a little of what I know…
depreciation is an accounting artifact.
Accrual accounting likes to record revenues and expenses in the period that they actually happen. That isn’t necessarly when cash is exchanged.
When you buy a long lived asset it provides economic value over a certain time period (usually). Accrual accounting would spread the expense of acquiring a long lived asset over potentially many periods. A house is depreciated , in other wordds expensed over 27.5 years or something like that for tax purposes. (your income is reduced by the value of the building, not the land, and you pay less taxes)
The interesting thing about depreciation is that it is a non-cash expense.
Why does it exist? In simple naive theory capital expenditures should match depreciation over the long term in a business that is neither contracting or expanding, whether you pay in cash or not.
Do captital expenditures and depreciation line up in real life? I don’t know, but I really doubt it!!