Depreciation is not directly a source of cash. But properly taken, depreciation can help a business owner, property owner or other owner of capital substantially improve cash flow. This is because depreciation is a form of tax deduction, designed to account for the routine wear and tear or obsolescence of certain kinds of property.
If you make a capital investment, you typically cannot deduct the entire investment in the first year you make it, although there are exceptions. More commonly, you will deduct a portion of the price you paid for the property or equipment every year until you have deducted the entire price paid, or your basis. Your basis can also include prices you paid to maintain or remodel the property.
When you make an investment in capital property with money on which you pay taxes, you build up a tax basis in that property. The IRS puts property in a number of different categories depending on the expected useful life of the property. For example, a computer is considered five-year property, while a building is considered 30-year property. Generally, you deduct the cost of the property from your taxable income in increments over the life of the property.
In some circumstances, you may accelerate depreciation, or even take advantage of special exceptions to take your depreciation deduction all at once, such as for certain kinds of utility vehicles under Section 179. The more you are able to deduct in a given year, the higher your after-tax income. So while depreciation does not generate cash directly, it does help you improve your cash flow situation on an after-tax basis.
Qualifications for Depreciation
To qualify for the depreciation deduction, the property must have an expected useful life of longer than one year, and must have been placed into service for the purpose of generating a profit. You cannot depreciate land, though if you are exploiting land for minerals, you may be able to take a depletion deduction for it. You can depreciate leased property, provided you maintain the "incidents of ownership," including title, a legal obligation to pay, the risk of loss if something happens to the property, and the obligation to pay taxes on the property. If the leasing company retains these incidents, you cannot depreciate the property on your taxes.
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