For many of you who know me, know that I am NOT a numbers person. I hate accounting and love paying my accountant to do the work for me. Even though that is the case, I still need to understand general principles of taxes and learning what is straight line depreciation has really helped me in my business.
By being knowledgeable of straight line depreciation, I am preparing myself to save as much money in taxes as possible and you can too.
Honestly, I am not an accountant, not do I want to be. 🙂
As I run my real estate investing business, I have found some things that have helped me and I want to pass them on to you.
In figuring out depreciation, I came across the straight line depreciation method. It is just one way to depreciate an asset and is fairly simple to use and apply in your business but it is a good one.
What is Straight Line Depreciation?
Straight line depreciation is a way to depreciate an asset over its useful life. Just as the name suggests, it depreciates the asset in a straight line, from the full purchase value, to the end where it is worth nothing at the end of the useful life of the asset.
The method was made to reflect an underlying asset’s pattern of consumption. This is also used when there is no specific pattern on how the asset is used in time.
The Straight Line Depreciation method is the easiest to calculate, resulting to the least number of errors in calculation. This is why it is highly recommended to use straight line depreciation to calculate the depreciation of an asset.
Straight Line Depreciation Formula
To know your assets’ value with the use of the straight line depreciation method, there are three figures you will need:
The asset’s purchase price
This refers to the original cost that you paid for your asset, including shipping, taxes, and other related fees.
The asset’s salvage value
It refers to the amount that you feel the asset can be sold for once it is no longer of use to use.
For example, if your asset is a car, it will be the amount that the vehicle can still be sold for in a scrap yard.
The asset’s estimated useful life
In simple terms, this is the amount of time that you can use the asset before you can sell it at its salvage value. The estimated useful life is being measured in terms of years.
After you have prepared all of these figures, follow this formula to calculate depreciation with the use of the straight line depreciation method:
Straight Line Depreciation Rate = (Purchase Price – Salvage Value) / Estimated Useful Life
When you have calculated the annual depreciation rate, you just have to subtract the depreciation value from purchase price every year to know the current value of the asset at any specific point in time.
What is the Straight Line Depreciation Method?
Depreciation is the accounting method of assigning the cost of an asset over a certain period of time to treat an asset’s value acquired by a business.
The moment a company acquires an asset, this doesn’t get expensed suddenly during the time of acquisition.
Instead, it gets divided over a specific period of time or over the useful life of the asset. There are numerous forms of depreciation method but straight line depreciation method is the most common.
In the straight line depreciation method, there is an assumption that the asset undergoes a uniform depreciation throughout its useful life.
The asset’s cost is spread evenly throughout its functional and useful life. This means that the depreciation expense on income statement stays the same for a specific asset throughout the period.
As a result, the income statement will be expensed evenly as well as the asset’s value on the balance sheet.
The asset’s carrying amount on the balance will reduce by the similar amount.
How Many Years of Straight Line Depreciation?
Straight line depreciation is considered as the simplest way of calculating the depreciation or loss of value of an asset over time.
This comes in handy in bookkeeping to evenly spread an asset’s cost over several years.
This is also useful for calculation of income tax deductions although this only applies for certain assets such as software, patents, and nonresidential property.
Straight line depreciation spreads an asset’s cost evenly throughout its useful life.
For instance, if you buy a machine worth $20,000 that you expect to use for 5 years, the cost is going to be written off as $4,000 for every year that you use the machine.
This is what sets straight line depreciation apart from other similar methods such as Sum of the Years Digits and Double Declining Balance that report higher costs early on then less in the following years.
Such methods are often recommended for items such as electronics and cars that usually lose their value at a much faster rate.
Straight Line Depreciation Definition
Straight line depreciation is defined as the default way of recognizing a fixed asset’s carrying amount evenly throughout its useful life.
This is used of there is no specific pattern on how the asset is going to be used over time. It is highly recommended to use straight line depreciation method because this is the easiest to calculate out of all depreciation methods, resulting to fewer calculation errors.
The steps to calculate straight line depreciation include the following:
- Identify the initial price of an asset recognized to be a fixed asset.
- The asset’s estimated salvage value should be subtracted from the amount stated on the books.
- Identify the asset’s estimated useful life. Using the standard useful life for every asset class is easier.
- Divide the asset’s estimated useful life in terms of years into 1 to determine the straight line depreciation rate.
- The depreciation rate should be multiplied by the cost of the asset less the salvage value.
After you finished calculating, the depreciation expense will be recorded in accounting records in the form of credit to accumulated depreciation account and a debit to depreciation expense account.
The accumulated depreciation is the cost asset account. It means that this reduces and is paired with the fixed asset account.
Examples of Straight Line Depreciation
Take a look at the following examples to understand how straight line depreciation works:
Example 1: Small Business
You have a small business and you decided to buy a brand new computer server priced at $5,000.
You have estimated that when its useful life ends, the parts will have a salvage value of $200 and you can sell them to recover some of the outlay.
The existing rules in accounting allow 5 years as the maximum useful life for computers.
Your business used to upgrade its hardware every 3 years so you consider this as a more realistic useful life estimate because you tend to dispose of computers during this time.
With this information in hand, you can then calculate the cost of straight line depreciation as follows:
- ($5,000 purchase price – $200 approximate salvage value) ÷ 3 years estimated useful life
- $4,800 ÷ 3
- $1,600 yearly straight-line depreciation expense
Example 2: Machine Value
XY Corporation buys a machine worth $60,000. Its estimated salvage value is $10,000 with 5 years of useful life. XY Corporation calculates the machine’s yearly straight line depreciation as follows:
- $60,000 purchase price –$10,000 approximate salvage value = Depreciable asset cost of $50,000
- 1 / 5-year useful life = 20% annual depreciation rate
- 20% depreciation rate x $50,000 depreciable asset cost = $10,000 yearly depreciation
Determining Salvage Value in Straight Line Depreciation
A company may buy long-lived assets like equipment, plant, and property that depreciate throughout their useful lives.
It is through depreciation that the Internal Revenue Service lets businesses and individuals expense part of the cost of an asset over a certain number of years.
The salvage value refers to the estimate of residual amount that you can receive once you dispose of an asset. Different methods of depreciation handle salvage value in different ways.
The Internal Revenue Service requires estimation of a reasonable salvage value.
This estimate should be made during the initial acquisition of the property. The property’s salvage value will depend on the length of time that it is used and how often you work on it.
If your goal is to extract every dime of value from the property, its salvage value could also be its junk value. But, if you plan to sell the asset before you exhaust its usefulness, a substantial salvage value can be justified.
If you decide to sell off a depreciated property for a price higher than its book value with the salvage value included, the gain should be treated as an ordinary income.
To determine the salvage value in straight line depreciation, first, you need to subtract this salvage value from the property’s cost and divide the value by the number of years in the useful life of the property.
The resulting figure will be the yearly fixed amount of depreciation. This is the amount that you can subtract every year until the depreciation becomes complete.
After completion, the property’s book value is going to be equivalent to the estimated salvage value.
Pro's and Con's for Straight Line Depreciation
There are several pros for straight line depreciation and these include the following:
- Straight line depreciation comes in handy for tax purposes for calculating a tax deduction for different intangible assets such as copyrights and patents.
- Straight line depreciation can be calculated easily and simply.
- Straight line depreciation can be used for reporting depreciation for different accounting purposes.
On the other hand, straight line depreciation also has some cons associated to it:
- Straight line depreciation presumes that the asset is going to have an equal decline in value throughout its useful life. But, majority of assets lose a big chunk of their useful life during its early years.
For instance, computers and cars lose their value during their initial years. During such instances, it is recommended to use sum of the years digits or double declining balance.
These methods of depreciation will both let you write off a higher depreciation amount during the earlier years then lower depreciation in later years.
Depreciation with Real Estate
Investing in real estate has several unique benefits as compared to stock market investments. There are several common regular deductions that are available to the investors.
However, there are several benefits associated with it, such as depreciation, that you are probably not aware of. Straight line depreciation refers to the depreciation of a real property in uniform amounts throughout the property’s dedicated lifespan that is permitted for tax purposes.
There are specific rules like for depreciation of rental properties and particularly condos or single-family and rental houses ready for renting out.
These are not applicable to properties that you plan to repair and fix up then rent.
When estimating the value of a property with the use of cost approach, the depreciation is being subtracted from total value.
As used in appraisals in real estate, depreciation has a somewhat different meaning as compared to its meaning in taxation. Depreciation is basically the loss of value because of all causes.
Most of the time, land doesn’t depreciate unless this is degraded by improper use, erosion, or probably changes in zoning.
Depreciation can either be incurable or curable. Curable depreciation refers to loss of value.
It could be corrected at a price less than the property value’s increase that will result if this were corrected.
On the other hand, it is not possible to correct incurable depreciation or it will also cost more than the property value’s appreciation.
Classify Depreciation for Specific Use
It is possible to classify depreciation according to the specific cause:
- Functional obsolescence – This is the loss of value that is associated with the features that the market has discounted like outdated plumbing, unfashionable design features, inadequate insulation, or heating or electrical systems.
- Physical deterioration – This refers to deterioration of the structures because of wear and tear.
- External obsolescence – This is the loss of value due to external factors like the surrounding environment, property, or any other factors that might decrease the value of the property like the municipality where the subject property is situated.
Even though different forms of depreciation may suggest improvements, calculating the actual amount can be difficult. This is why it may be a good idea to use a simplified straight line method for depreciation.
It will assume that depreciation will be linear throughout the structure’s lifespan, reducing in value at constant rate.
The yearly depreciation’s amount is calculated through dividing the structures’ cost by the expected lifetime.
For instance, if a property with a cost of $250,000 and land value of $50,000 is expected to last for 40 years, the yearly depreciation is going to be calculated as follows:
Value of House = Property Price – Land Price = $250,000 – $50,000 = $200,000
Straight Line Depreciation Conclusion
My first conclusion is that accounting is rough. That is why I pay my accountants to do all the work for me.
I am good at making money, not calculating the taxes on it.
I suggest using a good accountant and have them use the depreciation method they believe is best for your real estate investing business.
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