What is the Depreciation of Building?
Depreciation of Building refers to the process of reducing the recorded cost of a building in a methodical way till the time when the value of the building either becomes zero or reaches its salvage value. It allows us to map the revenue (say in the form of lease rental) generated during a period to the corresponding expenses.
The rate of depreciation for different types of building are categorized into the following three rate buckets, as shown below:
- 5% Depreciation Rate: The buildings that fall under the category of residential premises are depreciated at the rate of 5% under the income tax act. Buildings that are used for residential purposes except for boarding houses and hotels fall in this category. A building is considered to be used for residential purposes only if more than 66.66% of the built-up floor area is used for residential purposes.
- 10% Depreciation Rate: All other types that don’t fall under the category of residential premises are depreciated at the rate of 10% under the income tax act.
- 100% Depreciation Rate: Buildings that are mainly used for installing machinery and plant that form part of the water treatment system and water supply project fall under this special category. Further, wooden structures and tin sheds also fall under this category as they are purely temporary erections. These are depreciated at a special rate of 100%.
How to Calculate it?
Step 1: Firstly, determine the depreciable basis for the building under consideration. In case the property price is a combination of both buildings and land, then it can be derived by deducting the purchase consideration of the land from the overall amount paid, as shown below. Also, you can deduct the salvage value (if available) of the building for a precise valuation. (Take the help of a qualified accountant or an external appraiser to ascertain the depreciable basis for the building.)
Step 2: Next, determine the category of depreciation rate based on the nature of the property. It would be either 5%, 10%, or 100%, which would be used to calculate the annual depreciation of the building. The rate of depreciation can also be calculated as the reciprocal of the useful lifeUseful LifeUseful life is the estimated time period for which the asset is expected to be functional and can be put to use for the company’s core operations. It serves as an important input for calculating depreciation for assets which affects the profitability and carrying value of the assets. of the asset.
Step 3: Next, multiply the rate of depreciation and the depreciable basis for the building to derive the annual depreciation of the building, as shown below.
Step 4: Finally, capture the annual depreciation in the income statement in order to calculate EBITCalculate EBITEBIT is a profitability tool used to measure the operating Profits of a Company. You can calculate it either by, EBIT = Gross Sales – Company Expenses & Cost of Goods Sold, Or, EBIT = Total Profit + Interest + Taxes. (earnings before interest and tax). It is very important information for tax filing.
Let’s discuss the following examples for better understanding.
Let us take the simple example of a building bought for $100,000 and is estimated to have a salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000. of $8,000. Determine the annual depreciation of the building if the applicable rate of depreciation is 10%.
- Purchase price = $100,000
- Salvage value = $8,000
- Rate of depreciation = 5%
Now, the depreciable basis of the building can be calculated as,
Depreciable Basis = $100,000 – $8,000 = $92,000
Now, the calculation will be –
= $92,000 * 10% = $9,200
Let us take the example of a building bought by XDE Inc. to illustrate the concept of depreciation. The property was bought for $300,000, and it includes the purchase price of the land, which is $100,000. The building is estimated to have a useful life of 20 years, and at the end of the 20 years, the building is expected to have a salvage value of $10,000. Determine the annual depreciation of the building based on the given information.
- Overall combined price = $300,000
- Purchase consideration of land = $100,000
- Salvage value of building = $10,000
- Useful life = 20 years
Now, the rate of depreciation can be calculated as,
Rate of depreciation = 1 / 20 = 5%
Now, the depreciable basis of the building can be calculated as,
The depreciable = $300,000 – $100,000 – $10,000 = $190,000
Now, calculation will be –
=$190,000 * 5% = $9,500
Effects on the Financial Statements
- DebitDebitDebit is an entry in the books of accounts, which either increases the assets or decreases the liabilities. According to the double-entry system, the total debits should always be equal to the total credits. to depreciation expense results in a reduction of the net income, which eventually results in lower retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company. and shareholder equity.
- Credit to accumulated depreciationAccumulated DepreciationThe accumulated depreciation of an asset is the amount of cumulative depreciation charged on the asset from its purchase date until the reporting date. It is a contra-account, the difference between the asset's purchase price and its carrying value on the balance sheet. results in a reduction in the carrying valueCarrying ValueCarrying value is the book value of assets in a company's balance sheet, computed as the original cost less accumulated depreciation/impairments. It is calculated for intangible assets as the actual cost less amortization expense/impairments. of building and the number of total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity in the balance sheet.
- Depreciation also helps in reducing the taxable income, which means lower tax liability.
So, it is an important part of the accounting methodAccounting MethodAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods. that facilitates the maintenance of true profitability in the income statement through the systematic conversion of capitalized assets into the expense.
This has been a guide to the Depreciation of Building. Here we discuss the formula for calculating the depreciation of building along with its examples and effects. You can learn more about financing from the following articles –