Wednesday, October 12, 2016

How does Tax Depreciation Work?

The tax system is complex for businesses. One of the features is that it allows businesses to recognize depreciation of assets. Most governments do this in some form to encourage investment.

If you spend $1,000 for an asset that is allowed to tax depreciate over 10 years, you can subtract $100 per year from your income each year for the next 10, until the tax value goes to zero. So you pay less in normal taxes at your tax rate. This reflects the value from a tax perspective, not the actual market value. To emphasize, virtually all governments allow this recovery of costs on an accelerated basis to encourage investment.

If you then sell the asset for $50, you owe taxes on the $50 (sales value minus depreciated value of zero). Likewise, if you can get $1,200 for the asset, you would owe tax on the full $1,200. Equipment and machinery tend to go down in market value over time and with use, whereas historically, property appreciates. Even then, the gain is taxed at the lower long-term capital gains rate, rather than as normal income.

There's an important exception. If you die before selling it, the asset assumes a fair market value on it, so when they sell it, no taxes will be due. The tax value reverts to the fair market value upon inheritance. This is a really big tax advantage for those who inherit property or stock which may have appreciated.