When purchasing investment property, most people focus on the benefits of cash flow and passive income. However, there’s an even greater benefit that is often overlooked and not completely understood, until you’ve owned property for a period of time- Depreciation. Simply put, depreciation allows you to write off the buildings and improvements over a period of time, giving you a “phantom expense” that you can use as a write-off during tax time.
Real Estate is, essentially, dirt with things like buildings, houses, etc attached to it. You are NOT allowed to write off the dirt, because dirt will always be dirt, but you are allowed to write off the physical structures attached to it! The government sees those buildings and the improvements to them as having their own life and worth, essentially, nothing after their useful life. This is much like a company purchasing a piece of equipment (i.e. a truck or tractor) and having it lose value over time due to wear and tear- thus, DEPRECIATING in value. The same concept holds for Real Estate.
For whatever reason, the U.S. government has come up with two separate schedules for depreciation of Real Estate:
1. Residential property and improvements- 27.5 years
2. Commercial property and improvements- 39 years.
So, for example: let’s say you purchase a piece of property for $80,000 and the land (dirt) it sits on is valued at $15,000. Assuming your closing costs are $1,000, here’s what would happen:
$80,000 (purchase price)
+ $1,000 (closing costs)
$81,000 (total acquisition cost)
– $15,000 (subtract lot value)
$66,000 (amount to be depreciated)
= $2,400 per year!
In this example, one rental house purchased for $80,000 would yield an annual tax write-off (depreciation expense) of $2,400. If you had 10 of these, you’d be able to write off 10x this amount, or $24,000. Now, imagine if you had 20 of these properties, 30, or 50! You could actually get to a point where your depreciation expense exceeds your income and you actually could report that YOU LOST MONEY! This is why professional landlords and seasoned buy-and-hold investors don’t pay taxes.
The catch is you have to hold onto the property for a long period of time, or risk having to pay taxes on the back end when you sell. For example, say you sold your $80,000 property for $120,000 10 years later, your capital gain would be $40,000… BUT, you’d also have to ADD DEPRECIATION back in ($2,400 x 10 = $24,000) = $40,000 + $24,000 = $64,000.
There are ways around this also, such as a 1031 exchange or seller financing/installment sale method, please consult with your CPA for additional information. This, perhaps, is one reason why seasoned investors prefer to hold onto their assets…. FOREVER! Depreciation is a tremendous benefit afforded by those who buy-and-hold investment real estate.
For more information about depreciation, and the other write-offs that exist for rental properties, please consult with your CPA. If you have any questions about our company or would like to discuss opportunities with us further, please visit the CONTACT US page. A representative from our office will be in contact with you within 24 hours.