Tax Benefits of Real Estate Depreciation
Real estate has long been know as an investment vehicle that can produce income for its owners in a more tax efficient way than other investment options. There are several different tax strategies that are involved with real estate investing and today we will examine the topic of depreciation. Through the proper use of depreciation the taxpayer can eliminate or reduce the income they are receiving from the property they own. Here is an overview of depreciation and how it works.
What can be depreciated?
Property may be depreciated if is meets the following criteria:
- The tax payer owns the property
- The taxpayer uses the property in business or income-producing activity(e.g., rental property)
- The property has a determinable useful life
- The taxpayer expects the property to last more than one year
A taxpayer cannot depreciate personal-use property. The depreciation deduction is allowed only on the part of the property that is used for a burins or income producing activity. In particular in this article I will focus on the depreciation of residential rental property. In this case a taxpayer must use a straight-line depreciation method meaning they must deduct an equal amount each year throughout the property’s recovery period. In the case of residential rental property the recovery period is 27.5 years.
How Depreciation Works
As we determined above, straight-line depreciation must be used for residential rental property and used over a 27.5 years.
Here is a quick example from The Balance Small Business:
Using an investment fourplex as an example, begin with a purchase price of $325,000. Assume the property will generate $15,192 a year in positive cash flow if all four units are rented out full time.
Now you can offset some of that income for tax purposes. You can depreciate the building by deducting out the value of the land and dividing the remainder, the building value, by 27.5 years to reach a figure for annual depreciation.
The depreciation calculation would look like this:
- Purchase price less land value equals building value
- Building value divided by 27.5 equals your annual allowable depreciation deduction
Assume that the value of the half-acre of land on which the fourplex sits is $80,000. The calculation would look like this:
- $325,000 less $80,000 equals $245,000 building value
- $245,000 divided by 27.5 years equals $8,909 a year in depreciation
Without taking any other property tax or mortgage interest deductions into account, you’ve already reduced your taxable rental income by $8,909 annually. And you didn’t have to spend any additional money to realize this deduction.
The benefit is that the depreciation amount is used to directly offset any income that you have from the property. If this amount results in a loss this loss can be used to offset other passive income gains. Keep in mind that when/if you sell the investment property there may be a depreciation recapture that would get added to your gain amount and may be taxable to you. Depreciation does not lower the income that you physically can receive, however, in the eyes of the IRS it does reduce your taxable gain on investments. This is a great benefit for real estate investors.
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