What is Capital Depreciation? How does it work?

What is Capital Depreciation? Capital depreciation refers to the decline in value of a capital asset.

Depreciation is a method that measures the reduction in an asset’s value over the course of its life span. It also represents how much of an asset’s value is depleted due to usage, wear and tear, or obsolescence.

Causes Of Depreciation

Depreciation can occur in various ways.

1. Depreciation can be due to the repeated usage or physical condition of the asset, and time plays a vital role. In theory, the value is lost the more something is used over time and thus losses some value. One component of usemay be normal wear and tear for instance.
2. Depreciation due to obsolescence. Purchasing a car can holds it’s own depreciation such as it losing its value each year, it may be already an older model by the next year, let alone obsolete in 5-10 years’ time. As time goes on, despite the factor of wear and tear and usage, assets will become obsolete. The asset will use its value over a course of time. 
3. Depreciation due to change in market demand. When an asset becomes less desirable the demand will decrease, and the value of the asset will decrease as well. 
4. Depreciation due to the resale value of the asset. Any assets that can be re-sold will also experience depreciation due to wear and tear, as well as changes in ownership. One might assume that if the assets has acquired another owner it is because the previous owner was not satisfied with the asset and some value will be lost.

What Is Depreciation Rate?

The depreciation rate is the percentage rate at which asset is depreciated across the estimated productive life of the asset. It can also be defined as the percentage of a long term investment done in an asset by a company which company claims as tax-deductible expense across the useful life of the asset. It is different for each class of assets.

By convention, most U.S. residential rental property is depreciated at a rate of 3.636% each year for 27.5 years.

Depreciation Methods

There are various types of depreciation methods:

1. Straight Line Depreciation – Straight line depreciation is a common method of depreciation where the value of a fixed asset is reduced over its useful life.

   As for a real estate property’s useful lifespan, the IRS decided that:

   • The useful life of residential rental property is 27.5 years
   • The useful life of commercial property is 39 years

   Using this information, here’s an example:

   Let’s say we purchased a rental property for $100,000.

   First, we have to determine how much of that cost represents the land and how much covers the structure.

   Let’s say we determined that the cost of the land was $30,000. That would leave $70,000 as the cost of the building.

   Because this is rental real estate, we take the building value and divide it by 27.5 years:

   $70,000 ÷ 27.5 years = $2,545.45

   That would give us an annual deduction of $2,545.

   That’s a pretty good break on your tax return, every year, for 27.5 years.

2. Double Declining Balance Depreciation – double declining balance depreciation method is a form of accelerated depreciation that doubles the regular depreciation approach. It is frequently used to depreciate fixed assets more heavily in the early years, which allows the company to defer income taxes to later years. 
3. Units of Production Depreciation – Units of production depreciation is a depreciation method that allows businesses to determine the value of an asset based upon usage
4. Sum of Years Digits Depreciation – Tum-of-the-years’ digits (SYD) is an accelerated method for calculating an asset’s depreciation. This method takes the asset’s expected life and adds together the digits for each year; so if the asset was expected to last for five years, the sum of the years’ digits would be obtained by adding: 5 + 4 + 3 + 2 + 1 to get a total of 15. Each digit is then divided by this sum to determine the percentage by which the asset should be depreciated each year, starting with the highest number in year 1.

Unique Benefits of Depreciation for Real Estate

The benefits for Real Estate Investors is that property doesn’t often lose market value, unlike other assets. 

Even if the value of the property increases over time, because the value of the building depreciates, it reduces its tax liability, which in turn reduces the amount of tax that needs to be paid.

1. Depreciation can change a cash-positive rental to a negative-cash-flow property eligible for tax deductions.
2. Depreciation isn’t the only tax credit available

Investors can also get tax breaks on things like property maintenance and other expenses, which can decrease the net rental income.

With less net income, more tax cuts are allowed, resulting in a lower tax liability.