What is depreciation?

As time passes, the value of most physical assets decreases due to malfunction, wear and tear. For instance, if you buy a machine for your factory, you can expect the resale value of the machine to reduce over the course of its life. This will be due to the concept of depreciation. Any asset that can have a finite useful life has the potential to depreciate. 

Straight-line depreciation

The most common form of depreciation used in accounting practices is straight-line depreciation. This method assumes a fixed amount of depreciation per year throughout the useful life of the asset, which can be calculated by dividing the cost of the asset by the years of useful life of the asset. 

How this concept can relate to your personal finances

If you are buying a property with the intention of renting it out, you can use depreciation to your benefit. As soon as your property is put up for rent, it starts depreciating, usually at a rate of 3.636% each year for 27.5 years. You can use this depreciation amount as a deduction on your tax filings to reduce the amount of taxes you pay. You should check this link to get more information on IRS requirements for depreciable assets. 

You can also use depreciation to get a better picture of your net worth in relation to the market. Deducting appropriate depreciation expenses from your net worth can give you an idea of how much cash you would get if you liquidated all of your invested assets at their fair market value.