Real Estate Depreciation

Grant Wydeven
Real Estate Tax Depreciation

You’ve most likely heard that real estate has great tax benefits. And though that’s very true most people aren’t aware of them all. One in particular that’s going to become your best friend is real estate depreciation.

What is Real Estate Depreciation?

“Real estate depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property placed into service by the investor. Depreciation is essentially a non-cash deduction that reduces the investor’s taxable income.” –homeunion.com

Investors refer to this as a “paper loss” or “phantom” expense because you’re not actually writing a check. It is instead, the IRS allowing you to take a tax deduction based on the idea the real estate will decrease in value from wear and tear over time.

Tax Benefit of Depreciation

The benefit is to lower your overall tax responsibility thanks to real estate depreciation eating away at your taxable income. This can help investors save hundreds, thousands, if not millions a year depending on your portfolio size.

Real Estate depreciation is one of the four ways investors make money with real estate alongside cash flow, mortgage pay down and appreciation. Calculating these 4 things can help answer the question, is real estate a good investment?

Real Estate Depreciation Calculator

Here are 3 simple steps to help calculate real estate depreciation on your investment property over the course of the depreciation schedule.

  1. Real estate is a combination of land and building value, however only the building can be depreciated. So the first step is determine the value of the building itself, not including the land.
  2. The IRS has determined that real estate has a prescribed useful life of 27.5 years for residential properties and 39 years for commercial properties. Divide your building value by 27.5 to get your depreciation expense.
  3. Multiply the depreciation expense by your marginal tax rate to get your property tax savings from real estate depreciation.

Use this handy depreciation calculator.

Residential Real Estate Depreciation Schedule:

For this calculation we’ll be using a $300,000 single-family residential home purchase.

  1. Separate your land and building values, which you can also get from a tax assessment. Here, land value is $100,000 and building value is $200,000.
  2. Divide your building value by 27.5, which is the number of years IRS has prescribed as the useful life of a residential property. This is your annual depreciation of your residential investment property. ($7,272/year in depreciation)
  3. Multiply this annual depreciation by your marginal tax rate. If you need more information on the marginal tax rate, click here.

Commercial Real Estate Depreciation Schedule:

For this calculation we have a $2,000,000 commercial warehouse.

  1. Separate your land and building values, which you can also get from a tax assessment. Here, land value is $700,000 and building value is $1,300,000.
  2. Divide your building value by 39, which is the number of years IRS has prescribed as the useful life of a commercial property. This is your annual depreciation of your commercial investment property. ($33,333/year in depreciation)
  3. Multiply this annual depreciation by your marginal tax rate.

*If you’re interested in starting real estate investing but have little capital to work with, I have a guide on how to invest in real estate with no money and bad credit.

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What Investment Properties Can Be Depreciated?

In order for a real estate to be depreciated and for you, the investor or business owner, to benefit in the form of less tax liability, the property must meet certain requirements. These shouldn’t be too hard to meet.

  • The taxpayer must possess the rental property and may also depreciate any capital improvements for property the taxpayer leases.
  • The property must be used in a business or income-producing activity. If a property is used for business and for personal purposes, the taxpayer can only deduct depreciation based only on the business use of the property.
  • The property must have a determinable beneficial life of more than one year.

What Is Depreciation Recapture?

“Depreciation recapture is the gain realized by the sale of depreciable capital property that must be reported as ordinary income for tax purposes. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is thus “recaptured” by reporting it as ordinary income.” –Investopedia

Depreciation recapture is reported on Internal Revenue Service (IRS) Form 4797

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