The Basics of Depreciation for New Real Estate Investors
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What is Depreciation?
Depreciation is the acknowledgment by the IRS that tangible real estate assets wear out over time and thus lose value. It allows real estate investors to write off a portion of the property’s cost each year against their rental income, reflecting the property’s consumption or use over a period. It’s important to note that depreciation only applies to the building or improvements on the land, not the land itself, as land is not considered to wear out over time.
How Depreciation Works
To calculate depreciation, you need to determine three key elements:
The Basis of the Property: This is the amount your property is worth for the purposes of depreciation. It generally includes the purchase price plus any closing costs and costs for improvements (not repairs or maintenance).
Recovery Period: For residential rental property, the IRS has set the recovery period at 27.5 years. This means you can deduct the value of your property over this time frame. For commercial property, the recovery period is 39 years.
Method of Depreciation: The most common method used is the Modified Accelerated Cost Recovery System (MACRS), which allows for a larger depreciation deduction in the earlier years of property ownership.
Example of Depreciation Calculation
Assume you purchase a rental property for $275,000, with $25,000 of the purchase price allocated to the land and $250,000 to the building. Using the straight-line method under MACRS for a residential property, you would divide the building's cost by the recovery period (27.5 years):
Annual Depreciation Expense = $250,000
27.5 = $9,090.91
This means you can deduct $9,090.91 from your rental income each year for 27.5 years, reducing your taxable income.
Benefits of Depreciation
The primary benefit of depreciation is the tax savings it offers. By reducing taxable income, investors pay less in taxes, enhancing the profitability of their investment. Additionally, since depreciation is a non-cash expense, it does not affect the cash flow from the property, allowing investors to benefit from tax deductions without actual expenditure.
Considerations and Recapture
It’s important for investors to be aware that if they sell a property for more than its depreciated value, they may have to pay depreciation recapture tax, which is taxed as ordinary income. This recapture tax applies to the portion of the gain related to the depreciation deductions previously taken.
Conclusion
Depreciation is a valuable tool for real estate investors, offering significant tax advantages and contributing to the overall return on investment. Understanding how to properly calculate and apply depreciation deductions can significantly impact the financial performance of your real estate investments. As always, it’s advisable to consult with a tax professional or accountant who is familiar with real estate investing to ensure compliance and maximize your tax benefits.
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