“Depreciation” is an expense of doing business. It arises because certain types of costs provide economic benefits that span more than one accounting period. Instead of recognizing all of the cost in the first period, one spreads the cost over the relevant time period using one of a few different accounting methods.
For example, imagine that a company spends $300,000 on a building that has an economic life of 30 years. The company’s tenant has signed a 30-year lease for rent of $15,000 per year. Without depreciation, the company have revenue of $15,000 in the first year offset by a $300,000 cost for the building, for a loss of $285,000. In subsequent years, the company would have $15,000 in revenue but zero costs.
These numbers do not comport to economic reality. Instead of losing all of its value in the first year, the building slowly loses value over the term of the lease. A better way to account for this is to “depreciate” the building over the thirty years. A simple method of depreciation divides the capital cost by the building life. Thus, a $300,000 building depreciated over 30 years incurs a depreciation cost of $10,000 per year. Rent is $15,000. The difference is taxable income: $5,000 per year for 30 years.
For accounting purposes, “depreciation” shows up as an expense. However, other than in the first year no cash is being paid out for depreciation. It’s a “non-cash” expense. The owner of the building receives the full $15,000 and has no cash expenses. But for income tax accounting, the owner can offset the income to the extent of annual depreciation. The cash flow is $15,000 but the income is only $5,000.
The depreciation expense reflects the deterioration in the value of the building over time. If the owner wants to maintain the value of the building, then he will need to put money back into it in the form of repairs. If costs do not change, the annual expenditure required to maintain the value of the building should be approximately equal to the annual depreciation expense.
An unsophisticated income investor could easily confuse cash flow and income, to his detriment. As a matter of policy, management can choose to distribute all available cash flow and not reinvest to maintain the value of a partnerships assets. In this case, the assets will have no value on termination of the partnership because they have not been maintained. The investor may be surprised to discover that he received generous dividends for many years, but that his capital has disappeared in the end.
An unscrupulous promoter may go even further by describing the dividend as partly “tax free.” The portion of the dividend that is equal to depreciation represents a return of capital. The return of capital/depreciation may not create a tax liability, but it is not without cost. The cost is the diminishment of the investor’s capital.
If one wants to avoid these problems, one should compute the dividend yield using only the income portion of the distribution. Ignore the portion of the dividend that is depreciation. One can identify the depreciation by reading the statement of cash flows.