One of the unique advantages of real estate investing is the tax benefit it offers. This benefit is largely due to the concept of depreciation.
Depreciation and Taxes
Most people recognize that business expenses are deductible. Labor, cost of goods sold, and equipment purchases are all expenses that reduce typical business’s taxable income. In the case of equipment purchases, they must typically be deducted from income over the expected useful life of the equipment purchased. Depreciation occurs by deducting an expense over time.
For example, a construction company purchases machinery for $80,000 that has an expected life of 10 years. Rather than taking a deduction of the full amount, the Internal Revenue Code (IRC) allows the company to write off $8,000 per year for 10 years. It recognizes the depreciation in the value of the machinery.
Similarly, the tax code allows owners of income property to deduct the cost of any equipment they purchase – including the cost of the buildings themselves. But unlike most equipment, which really does wear out and loses value over time, buildings typically grow in value as time passes. And, unlike other costs associated with operating a property (i.e. taxes, insurance, maintenance, etc.), which are actual, out-of-pocket expenses for a landlord, depreciation is a deduction that does not reflect a real cost to the owner.
In other words, this depreciation deduction essentially allows the owner to treat the property as though it were declining in value. You can do this even as the property steadily increases in value. Let’s see how this might work with an actual income property investment.
How Depreciation Works Over Time
Suppose you purchase a 4-plex for $380,000, with a monthly cash flow of $500. When you calculate your tax obligation for the year, determine how much of the building’s cost was in the value of the land. Buildings could depreciate, but land cannot. Let’s say that you allocate $70,000 to the cost of the land. The remaining $310,000 is allocated to the cost of the building.
Residential income property depreciates over 27 ½ years. So, we would divide $310,000 by 27.5. With this formula, we find that we can take a deduction of $11,272.73 each year for depreciation. Remember, we had a positive cash flow of $500 per month after operating expenses and debt service. That is $6,000 per year. However, after the $11,272.73 deduction allowed for depreciation, the entire cash flow of $6,000 would be offset. This means no tax liability incurs. In fact, the property would actually be showing a “paper loss” of $5,272.73 for the year. In other words, the $6,000 you made from your property was tax-free! Furthermore, you could have a loss to use as an offset to other income you may have earned during the year.
Being able to legally claim that you are losing money is a benefit to real estate ownership. Understanding depreciation can be as important as any other consideration.