One of the main financial benefits of an investment property is that its value can be depreciated over its useful life. That depreciation in turn reduces your taxable income, but not your actual cash flow.
What is Real Estate Depreciation?
Basically, depreciation helps real estate investors get rich! Real estate depreciation is a non-cash deduction that reduces the investor’s taxable income. Assume you make $10,000 in operating cash flow on an investment property, and then you have $8,000 of depreciation. The depreciation reduces your taxable income to only $2,000. The IRS allows investors to take this deduction based on a perceived decrease in the value of the real estate.
Real estate depreciation assumes that wear and tear reduce the value of a rental property over time. But we know this is not typically the case. Not many other forms of investment offer comparable depreciation deductions. This depreciation offset against actual cash flows, an investor may actually have real cash flow from the property while showing a tax loss.
Benefit of Investment Property Tax Depreciation?
Depreciation lowers the overall tax liability. Many real estate investors can generate real income while paying nothing in taxes. This can help real estate investors save hundreds to thousands per year on their taxes, all totally legally.
Required for Depreciating Investment Properties for Tax Deduction
There are several criteria required to depreciate the value of a property:
- Taxpayer must possess the rental property and may also depreciate any capital improvements for property the taxpayer leases.
- Property must be used in a business or income-producing activity. If a property is used for business and for personal purposes, only the portion dedicated for business use can be deducted.
- Property must have a determinable beneficial life of more than one year.
How It Works
Land is not depreciable. But assuming you have rental real estate, you can depreciate the building, significant improvements, and any equipment that is used in the operation of the property. Depreciation begins when a taxpayer places property in service and ends when the property is disposed of or otherwise retired from service. Any depreciation that was taken will reduce the investor’s basis in the property. Upon disposition of the property, this depreciation is essentially recaptured.
Calculate Real Estate Depreciation in 3 Simple Steps
- Real estate value is made of land and building values, but depreciation only applies to the building. First step is to allocate the property’s purchase price between land and building value. If now specified in the Deed, real estate tax records can be used for this. A township’s tax records will typically split land and improvement values in the tax assessment calculation. Assume that a residential rental property has land value of $100,000 and improvement value of $400,000.
- Since land is not subject to depreciation, the building would be depreciated over the IRS prescribed useful life. This life is designated as 27.5 years for residential rental property and 39 years for commercial property. Divide your building value by 27.5 to get your depreciation expense. In this case, $400,000/27.5 = $14,545 in annual depreciation expense.
- Multiply the depreciation expense by your marginal tax rate to get your property tax savings from real estate depreciation. Assuming a marginal tax rate of 35%, you effectively save $5,091 per year ($14,545 x 0.35). That is the amount of tax you avoided by being able to depreciate your investment property.
Real estate depreciation is a critical tax deduction for real estate investors and should not be overlooked. It is important for the real estate investor to understand the basics of depreciation, which will help with tax planning and understanding actual after-tax returns.
