Understanding the Magic of Depreciation

Depreciation is generally defined as the lessening in value of an asset with regard to wear and tear or use over time.

More specifically in real estate, depreciation implies this same concept of wear and tear and “using up” an asset - but takes it a step further and actually is a tax saving tool.

A simple example in the business world is if a company had to pay $10,000 for a truck, they wouldn’t actually count that full $10,000 as an expense in the year that they bought it. For taxes, instead of counting that expense in one year, they basically spread out that truck expense over how long the truck could be used, aka the “useful life” of the truck. So if the truck would last 5 years, the company would show $2000 expense for 5 years. Since the truck will be used by the company for 5 years, the IRS thinks this is a more accurate way to show the true expense of the truck. A similar thing happens in real estate investing.

When you buy property, the physical structure loses value (depreciates) over time - each physical component of it (down to the nails and boards that comprise the framing).  (This does not include the land itself - which is not subject to wear and tear.)

The beauty of depreciation is that the IRS allows you to take the value of the structure and all of its components - divide it by the amount of years of its useful life - and then take that yearly amount as a write off every year, whether or not any money was actually spent by the property owner.  

Let’s look at an example.  Let’s say you buy a 4-plex for $1,000,000.  And let’s say the land is worth $350,000 and the structure itself is worth $650,000.  The IRS would consider the “useful life” of that structure to be 27.5 years (which is the standard for residential and multi family real estate) - so you would divide $650,000 by 27.5 and get $23,636 depreciation per year.  This $23,636 is, again, a write off that the IRS gives you - whether you spent any money or not.  (If you did spend money improving or repairing the property, this would be written off in addition to the depreciation.)

This $23,636 then offsets income that you are making on the property, which looks like this:

+$100,000 Rental Income from the 4-plex

-$50,000 Mortgage Interest Payments

——————

$50,000

-$9,000  Property Management Company

—————

$41,000

- $18,000 taxes, insurance, repairs

————

$23,000 “profit”

Normally, the IRS would tax you on that “profit” of $23,000.  This is where the beauty of depreciation comes in. 

$23,000 “profit”

-$23,636 (depreciation)

————

-$636

Now you would report to the IRS that you LOST money on your rental property, therefore no tax! But you actually got $23,000 worth of cash. That is the magic of real estate depreciation.

A lot of investors arrange it this way so that the depreciation covers most or all of the net income which means that the investor is not paying taxes on real money received.  It even works if you have left over depreciation on one property and want to use it to cover revenue on another property that might still have some taxable income left on it.  (This -$636 in the above example could be transferred over to other properties that might still show some profit.)

In summary - yes, you put the money in your pocket but the IRS doesn’t tax you on it.

For someone unfamiliar with this, one would wonder why the IRS would allow this.  Well first of all, providing these tax breaks to investors would incentivize them to invest deeper and deeper into real estate.  This is good for the country because it essentially places the providing of housing in the hands of the private sector and it takes care of itself.  In addition, if investors constantly invest in real estate, this stimulates all kinds of good things for an economy (use of labor, purchase of materials, etc).  It also motivates investors to build more real estate which then provides the housing that a growing country needs (and more property taxes!).  And so on.  Suffice to say, real estate is very important to an economy and this type of tax incentive ensures bright and eager investors are staying involved and expanding.