Real Estate: How Depreciation Works
Depreciation is a Tax Deduction
Investors new to real estate are sometimes confused by how depreciation works. Depreciation is simply a tax deduction taken over the useful life of a property. Real estate investors are able to deduct depreciation expenses even though the property is appreciating in value. This is easier to understand if you recognize that the government is allowing depreciation to encourage people to invest in real estate. By taking depreciation expenses investors are able to keep more of the rent they collect each year which makes real estate a desirable asset to own.
Depreciation Reduces Taxable Income
For example, Morgan purchases a rental property and she earns $10,000 in rent for the year. Her expenses include $2,000 in property taxes, $500 for insurance and $500 for repairs. This is a total of $3,000 in out of pocket expenses. This leaves her with $7,000 in rental income ($10,000-$3,000 = $7,000). She also has $3,000 in depreciation for the year which means her taxable rental income is $4,000 ($7,000 -$3,000 = $4,000).
However, depreciation is unlike other expenses like property taxes or insurance because Morgan does not actually pay out of pocket for this expense. This is why real estate investors call depreciation a "paper loss". She will earn $7,000 in rental income but only pay taxes on $4,000 because of the $3,000 in depreciation she is allowed to claim.
Determining the Basis of a Property
The amount an investor can deduct for depreciation depends on the type of property they own, such as residential versus commercial. For residential investment properties, like a single family home, the Internal Revenue Service (IRS) allows depreciation over a 27.5 year period. To find the annual depreciation amount an investor first needs to determine the basis of the property, essentially what the property cost to acquire.
Cannot Depreciate Land
The IRS does not allow you to depreciate land. Therefore, investors must subtract the cost of the land from the price of the property they bought to find the basis. The property tax assessment may list the percentage of land value. For example, the property value is 20% land and 80% for the structures. A local tax professional can also help determine the value of land versus structures.
Basis Includes Some Closing Costs
The basis also includes certain closing costs related to acquiring the property. These include legal fees, recording fees, charges for installing utility services, transfer or stamp taxes, the cost of the buyer's title insurance and surveys that were done. All of these expenses are added to the basis and increase the amount of depreciation that can be expensed.
Real Estate Depreciation Example
Here is an example of how to find the basis and the annual rate of depreciation. Jake purchases a $400,000 single family home for cash and has $2,000 in eligible closing expenses to include in the basis. Jake determines that the land cost is $80,000 and the property cost is $320,000. Again, land cannot be depreciated, so it is not included in the basis.
Jake adds the $320,000 to the $2,000 in closing costs to find a total basis of $322,000. Jake then divides the basis by the IRS's depreciation figure for residential real estate of 27.5 which equals $11,709. Jake can deduct $11,709 in annual depreciation expenses against the rental income he earns from the property.
Since Jake paid cash for the property he does not have a mortgage payment or interest expenses to deduct. He has a tenant paying $2,500 per month or $30,000 per year. He is paying a property manager 10% to manage the property. At the end of the first year Jake's rental income and expenses are:
Rents collected $30,000
Property Management -$3,000
Property taxes -$5,000
Income before depreciation $20,000
Income after depreciation $8,291
Jake's out of pocket expenses for the year are $10,000 leaving him $20,000 in rental income. He can also deduct $11,709 in depreciation which means he only pays tax on $8,291 of his rental income, not the full $20,000. This is one of the key advantages of investing in real estate, Jake is able to keep more of this income to reinvest in other assets by taking advantage of depreciation.
The government likes to give, but it also likes to take away. The IRS grants depreciation to help investors lower their annual expenses which encourages real estate activity. However, once a property is sold, the IRS wants to "recapture" this benefit by taxing the total amount of depreciation taken. The rate for this recapture tax is 25% of the total amount of deprecation taken.
If Jake sells this property in ten years he will have taken $117,090 in depreciation over the decade. The IRS will tax him $29,273 as a recapture tax on the depreciation ($117,090 x .25 =$29,273). Jake will pay these taxes out of the proceeds from the sale. If Jake sold the property for a profit he will also owe capital gains tax on this income as well.
If Jake was smart with his annual rental income he would have invested it and will have generated returns that more than offset having to pay this recapture tax upon the sale of the property.
Other Real Estate Tax Strategies
If you want to learn about other real estate tax strategies see the articles on 1031 Exchanges and Passive Losses as well as strategies for Real Estate Negotiations and buying in today's Expensive Real Estate Markets.