7.1.3.2. Depreciation and Depletion
Assets wear out over time. Business accounts recognize this loss in value through a concept called depreciation. Depreciation represents the value of an asset that is lost over time, usually due to wear and tear. The IRS allows both DPPs and corporations to treat depreciation as an expense that can be subtracted from earnings before taxes are calculated. DPPs do not pay income taxes, but depreciation can be deducted from the DPP partners’ taxable income, reducing their tax due.
Depreciation applies to manufactured assets. When natural resources are involved, the similar concept of depletion is used instead. Depletion reflects the using up or “depleting” of a DPP’s natural resources, such as oil and natural gas.
Depreciation can be calculated in several ways. With straight-line depreciation, the asset is assumed to lose the same amount of value each year, so depreciation expenses are the same each year. As a means of encouraging businesses to invest in new assets, the IRS also allows accelerated depreciation. Accelerated depreciation is based on the idea that assets lose more of their value in the beginning of their life than later on; therefore, depreciation expenses are larger earlier in the asset’s life than later in the asset’s life. For example, a DPP may buy a $105,000 asset that it assumes will have a 10-year life and a salvage value of $5,000. Under straight-line depreciation, the depreciation expense would be $10,000 each year ($100,000 / 10 years). Under accelerated depreciation, the asset may depreciate by $30,000 in the first year, $20,000 the second year, and so on. With expenses higher in earlier years of the asset’s life, the DPP’s bottom line (net income) wil