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Understanding Depreciation
       

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One of the main benefits of owning real estate investments is "Depreciation". This is sometimes the most miss-understood item in real estate. Depreciation is an "intangible expense" that reduces the reportable taxable income from a property. This is a good thing as it puts more money into your back pocket and less into Uncle Sam's pocket.

Depreciation is a method of matching the "costs" of a property over it's estimated economic life. The IRS requires most all property to be depreciated when held for long term or for investment. The IRS generally requires you to use the straight line method for calculating your depreciation. Residential income properties are depreciated over 27.5 years and commercial buildings over 39 years.

Depreciation Calculations

It is important to remember that land can never be depreciated, only the improvements built upon the land is depreciated. Thus you need to exclude the value of the land from the total cost of your property. Course the main question most owners of income property ask is "How much is the land worth under my buildings?" The simplest way is to check you property tax statement. The County Assessor should have it broken down for you already on your annual tax statement. You can use that value or check with a tax advisor for guidance. The IRS typically does not challenge the assessment you use as long as it is "reasonable".

For example, say you have a duplex with an estimated value of $400,000 and your know the land value is $100,000. That makes the building improvements worth $300,000. Calculating the depreciated would be $300,000 divided by 27.5 years equals $10,909 dollars of "depreciation expense" that can be used to off set your profits on the property.

Ok lets do a full blown example. Using the property above. Say we have $24,000 in annual income from the property. To see what our taxable income from the property is that we need to report to the IRS at the end of the year, we would use this simple calculation:

Rental income minus all expenses minus depreciation equal total taxable income.

 

Rental Income

$30,000
Minus Operating Expenses

$5000
Minus Depreciation

$10,909
Equals Taxable Rental Income

$14,091
Minus Debt Service (loans)

$18,250
Equals Reportable Net Income

-$4,159

So in this example the Owner is showing a loss on the property for tax purposes. If the owner made less than $125,000 in regular income for the year, He/she could used the above $4,159 as a tax write off (deduction) against their regular income. Unfortunately the IRS rules limit this tax deduction for high income earners who earn more than $125,000 in regular income per year. As always, check with your tax advisor for your particular circumstances.  

 

Now for the bad news about depreciation. Upon the sale of an investment property, The IRS requires the payment of a "depreciation recapture tax". Its great that the Government gives Investors the gift of writing off or depreciation some of the cost of your investment in real estate, but when you sell or dispose of your investment, The government wants some of that gift back. Currently the recapture tax is at 25% of the total depreciation taken on your investment.

 So in the example above, if you held it for 10 years (10 x $10,909 = $109,090) you would owe 25% of $109,090 or $27,272 in "depreciation recapture tax. Plus any State and Federal capital gains taxes on the sale.

  This is why we highly suggest that you should use a 1031 Tax exchange when ever you sale a property, So you can defer the paying of capital gains taxes and depreciation recapture taxes into the future.

 

Otherwise when looking at Real Estate investments, Depreciation may be one of the best benefits. The tax advantage that it offers is powerful and one that every Investor should be taking advantage of.

As an added bonus you could also depreciate various items like fences, fixtures, appliances, etc, etc, at different depreciation schedules (which the IRS allows) that would allow you to take even a larger deduction for depreciation expense on your property. It is best to seek the advice of a good tax accountant who can give you more information on these items. Just ask him/her about "cost segregation" for depreciation purposes.

 

 
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and Creating Income with Residential Property Investments