The term “depreciation” may be a little confusing at first, when you’re used to thinking of real estate as an investment that will build equity over the years. Real estate doesn’t depreciate the same way that a car does, for instance, losing value over time. Nor can the same depreciation methods that apply to, say, machine tools in a factory be used for real estate.
Instead, depreciation is a concept that applies to rental property for tax purposes. Depreciation on buildings is a way to see a tax deduction by spreading and adjusting the costs of an asset over a given period of time. Depreciation on a building will reduce that asset’s adjusted cost basis (which takes in various other tax-related items).
Let’s say an investor has bought a four family home for $325,000. The IRS will allow depreciation over a period of 27 1/2 years, due to the fact that buildings do wear out or become “obsolete” with features that have fallen out of demand.
In effect, the maximum depreciation for a calendar year would be the building’s value divided by 27.5. In this particular example, we’ll assume that the lot on which the fourplex sits is worth $80,000, which leaves the structure itself at a value of $245,000. If we divide $245,000 by 27.5, we come up with a maximum $8909/year in depreciation.
Let’s say that the four family home realizes $15,192 in positive cash flow every year. After figuring in deductions for in repairs, local taxes, insurance, vacancy loss and direct expenses, with these depreciation methods that figure could be padded to close to $35,000. From that, subtract the $8909 in depreciation and the taxable income is back down in the range of $26,000 per year.
If a rental property is sold, depreciation is “recaptured” by the IRS and presents a tax liability for the seller that will have to be figured in with capital gains (though there are strategies to get around that as well).
Depreciation on buildings is mainly of interest to the real estate investor. Such arcane areas of IRS code are best left up to CPA’s and tax attorneys. This article hopes to shed some light on the question of “What is depreciation?”, but the fine points should be discussed with tax professionals.