Tax Credit Vs. Depreciation
Depreciation can be a difficult concept for some people. This is primarily because it is non-cash expense that does not get completely expensed in the year the asset is purchased. Additionally, not all assets are depreciable -- only those with an established useful life that bring value to an organization over a period of years. Tax credits may seem like the same sort of transaction, but they are really quite different.
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Straight-line Depreciation
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In order to understand the difference between a tax-credit and depreciation it is important to understand how depreciation is calculated. The most common method used to calculate depreciation is the straight line method which uses three primary variables to calculate an annual depreciation expense. The variables are the asset cost, the useful life of the asset and the salvage value of the asset.
Depreciation Variables
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The useful life is defined as the number of years an asset provides value to the company. The salvage value is the value of the asset after its useful life. The asset cost is the cost to purchase the asset, not the value of the asset. For instance, if you purchase a car for $10,000 and you think it's really valued at $12,000, the depreciable cost basis for the car is $10,000, not $12,000.
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Tax Credit
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A tax credit is not an expense or a reduction in net income. A tax credit does not adjust your net income at all -- it is subtracted from your tax bill. For example, if your tax bill is $10,000 for the year, and you get an $8,000 tax credit for purchasing an energy efficient vehicle, the tax credit is subtracted directly from the tax bill. In this example, the tax bill drops to $2,000 instead of $10,000.
Depreciation vs. Tax Credit
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Depreciation is an expense. Instead of subtracting the cost of the asset from revenues all at once, only a certain portion is subtracted every year. The amount subtracted is meant to coincide with the useful life of the asset. Depreciation reduces the reported net income for the company and a tax credit reduces the entire tax bill. The former is a cost of operating and the latter is an incentive for making a certain purchase.
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