By Christopher Miller, MBA Specialized Wealth Management
“Depreciation? I know it saves me money, but I’m not sure how.” This is a common school of thought among real estate investors – many of us just hand our numbers over to a CPA at tax time, and let them handle it. I had an electrician working at my house last year, and he wanted to tell me every detail of what he did. My answer was “as long as it works, it doesn’t matter to me.” This approach may work well when wiring your home, but it is important to know a little bit about how depreciation works. Fortunately, it isn’t too complicated, so I’ll review it in this month’s article.
Depreciation saves you money by sheltering your real estate income from taxes on an annual basis. You may have to pay it back later (if you sell without exchanging); but at a potentially reduced rate. The tax deferral properties of depreciation mean that it saves you money today and can therefore represent a significant percent of investors’ Real (meaning “in your pocket – after taxes”) return.
What is Depreciation?
If I turn this article into an accounting lesson, my readers will fall asleep long before the thrilling conclusion. Therefore, I’ll just summarize the basics. Again – this is intended to be a review only: not training to compile and submit your own taxes.
According to “Dictionary.com,” Depreciation is a decrease in value due to wear and tear, decay, decline in price, etc. It exists as a way to write down your “loss” that occurs through depreciation. For example: Let’s say a printing business buys a $100,000 press, and $1,000 of ink. The ink is written off in the current year as a business expense: the company’s income is reduced by $1,000 – so they don’t pay taxes on that money. The press, however, is a capital expense that can not be fully deducted in the current year. The company must pay income tax on that $100,000 of income that was spent on the press. Recognizing that the value of this property will decrease over time, the IRS allows this company to depreciate the printing press over 7 years. The company will, each year for the next 7 years, write off $14,285 ($100,000 / 7 years). This, in turn, decreases the company’s taxable income every year and is a way for the company to recover some of their tax outlay.
The business expense vs. capital expense distinction will sound familiar to those of you who take a closer look at your taxes. You can write off a plumbing repair as a business expense, but a new roof is a capital expense that must be depreciated over a number of years. (27.5 in that example.)
Note that; although real estate usually doesn’t decline in value with time, it does require maintenance. The depreciation deduction is granted to investment real estate owners in recognition of this circumstance.
You Can’t Depreciate All of Your Property
Unlike a printing press, real estate has a component that the IRS says never depreciates. Land is called an inexhaustible asset that does not depreciate over time. You may have purchased your apartment building for $1 million, but a taxpayer can not depreciate that full amount – the land component of the property is non-depreciable. A taxpayer must estimate what percentage of his property’s value is assigned to improvements, multiply that by his purchase price, and depreciate that figure over a number of years. Let’s use 80% as an example: That investor can depreciate 80% of $1 million, or $800,000, over the depreciable life of his property. This estimate would mean that 80% of this property’s value is due to it’s improvements, and the bare dirt is worth $200,000.
How Do I Estimate This Percentage?
Your CPA will estimate this percentage for you. He’ll probably use a “reasonable estimate” based upon the property’s appraisal. It is important not to use the property tax bill as your only guide – these aren’t developed with the accuracy of this ratio in mind: The assessor’s office charges you a percentage tax based on the value of the property – they don’t really care what % represents land vs. improvements value.
Depreciable Life of Residential Properties
Residential investment properties; from a single family home all the way up to a 3,000 unit apartment complex, are depreciated over 27.5 years. Using the example above, the investor would claim ([$1,000,000 X 80%] / 27.5) $29,090 per year over the next 27 ½ years as a depreciation deduction.
Depreciable Life of Commercial Properties
If an investment property isn’t residential, than it is considered commercial. Commercial properties are depreciated over 39 years. Let’s pretend the example property above was a small shopping center whose value was 80% assigned to improvements. The depreciation math would then give the investor ([$1,000,000 X 80%] / 39) $20,512 of annual depreciation.
Different classes of assets can be depreciated at different rates. For example: if you add a new master bedroom and bathroom on to your rental home, this new addition can be depreciated over 27.5 years. Carpets or appliances, however, can be depreciated over 5 years. This accelerated depreciation can help owners get their tax savings sooner.
Knowing the Fundamentals of Depreciation is Important
Because depreciation savings represent a significant part of a real estate investor’s after-tax return, it is important to understand the basics. Using depreciation more effectively can contribute to an investor’s success by providing them with more after tax money in their pockets.
Christopher Miller is a Managing Director with Specialized Wealth Management in Tustin, California and specializes in tax-advantaged investments including 1031 replacement properties. Chris’ real estate experience includes work in commercial appraisal, in institutional acquisitions for a national real estate syndicator, and as an advisor helping clients through nearly three hundred 1031 exchanges. Chris has been featured as an expert in several industry publications and on television and earned an MBA emphasizing Real Estate Finance from the University of Southern California. Call him toll-free at (877) 313 – 1868.
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