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Definition

Depreciation Tax Shield

What is Depreciation Tax Shield?

A Depreciation Tax Shield is a decrease in tax liability accomplished by trying to claim permitted exclusions such as itemized deductions, medical expenditures, charitable contributions, amortization, or depreciation. These exclusions can lower a taxpayer's tax liability for the current year or delay taxation for the coming years. 

Understanding Depreciation Tax Shield

Tax shelters reduce the quantity of income owing by a person or a corporation. People and corporations both profit from tax shelters. Businesses often adopt one of two significant techniques and they are -

  1. Improvement of capital structure
  2. Approaches of depreciation and amortization

A depreciation tax shield might help save on taxes, and the cash flow management will be improved. However, it is beneficial in tax planning, and the operational selection and the tax shield's advantages might be exploited for taxable income. This shield is critical in corporate finance for selecting the proper project.

Advantages of Depreciation Tax Shield

There are a few remarkable advantages of this specific tax shield, and they are -

  • Better management of tax costs with a depreciation tax shield
  • An excellent instrument for lawfully minimizing tax
  • A non-cash item; net cash earnings can be raised
  • Inverse proportion connected to tax payments — the larger the depreciation, the smaller the taxation
  • Aids in financial planning and determining whether to acquire the equipment and take advantage of the depreciation tax shield or lease the property

Practical Example

If a corporation depreciates $5,000 each year and the taxation rate is determined at 15%, the tax deductions for the year are $750. An accelerated depreciation approach will also assign more significant tax benefits in early periods but less in later times for depreciation. The tax savings are more remarkable for a higher deduction. However, it is critical to analyze the impact of transient discrepancies in amortization and total cost allowances for tax reasons.

In Sentences

  • A depreciation tax shield is one of the essential techniques in corporate finance to determine whether to buy or lease a property.

 

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