Depreciation is the expense claimed each year to write off a portion of a capital asset. You can claim this deduction over a number of years. Depreciation reduces your basis each year so that, when you sell the properly, your basis will be lower than it was when you bought it. The more depreciation claimed, the lower the basis and the higher your taxable profit.

Each asset is depreciated within guidelines established in tax regulations. The period of time is called a recovery period. Each type of asset has its own recovery period and each type can also be depreciated under a limited number of methods. Real estate¡ªbuildings and permanent improvements¡ªare always depreciated using the straight-line depreciation method. That means the identical amount is deducted each year, with the exception of the first year, in which the amount is prorated. Some other types of property, such as vehicles and office equipment, can be depreciated more rapidly than real estate, using accelerated depreciation. Under such a method, you are allowed to deduct more in the earlier recovery period years, and less later on.

An important point concerning depreciation is its relationship to leverage. Whether you put down a lot of money or very little, you calculate depreciation the same way¡ªbased on the price of the real estate and not on the amount of cash you put into the deal. The tax advantage is that depreciation is based on your basis, so the less capital you invest, the more value you get back from depreciation; that is to say, in comparing your cash investment to your tax advantage, a smaller amount of capital invested yields a greater dollar-for-dollar tax advantage.

For personal property, you are allowed to depreciate under three different recovery periods: three, five, or seven years. Each of the recover- periods allows the use of a modified form of accelerated depreciation. At the end of the period, the entire basis in the asset has been depreciated. Note that the period of depreciation requires one extra year to claim the last remaining part of the allowable depreciation. This is based on the method of depreciating assets that assumes property is bought halfway through the year on average. So for the first year, you get only six months' worth of depreciation¡ªand that leaves a half year's worth at the end as well. This rule, called the half-year convention, assumes that, on average, assets acquired in any one year are bought and put into service at the halfway point of the year.

While the half-year convention usually applies to personal property, buildings and improvements are calculated during the first year using the mid-month convention. This means that the first year's depreciation is calculated depending on ihe month you acquire property; you are allowed to deduct a percentage of the per-year depreciation based on the month purchased. Because the mid-month convention is used, each months percentage will reflect a percentage based on mid-month calculation, not on full-month calculation. For example, if you acquire property in January, you will be allowed to deduct 23/24ths of the calculation for that year (the full year less one-half month). And if you buy property in February, you will be allowed to deduct 21/24ths for the first year.

 

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