Why Depreciation is a Landlord’s Best Friend
If you invest in rental property, one of the biggest advantages you have is depreciation. You may have heard of some of the “tax advantages” of real estate investing. Now, the US tax code is over 60,000 pages long. Even CPAs don’t know every word of it. But one part of the tax code every real estate investor should understand is that the IRS allows you to claim “depreciation” of business assets as a tax write-off. That includes rental real estate.
What Is Depreciation?
What does depreciation mean? It essentially means you can write off “wear-and-tear” of the property as an expense. The idea is that the asset becomes less valuable every year due to this wear-and-tear, and you can deduct that loss of value.
Of course, one thing we know and love about real estate is that it often gets more valuable over time, not less. Yes, wear-and-tear might mean extra repair costs, but with the right property, your rental income will more than cover that.
In other words, the IRS is allowing you to write off an expense that doesn’t really exist. It doesn’t take money out of your pocket … but you still get to deduct it from your taxable income, lowering your tax burden every year without you having to spend extra money to get that deduction!
Homeowners don’t get to do this … only landlords. By law, you can’t take depreciation on your personal residence, just rental property.
How Much Do You Get to Write Off for Depreciation?
The IRS sets different “depreciation schedules” for different classes of assets. For real estate the current depreciation schedule is 27.5 years. Some real estate investors, especially buyers of large buildings, use a method called cost segregation to take accelerated depreciation, but for most small-portfolio landlords, 27.5 years will be the schedule.
What does this mean? It means that for 28 years, you can depreciate 3.636% (100% ÷ 27.5 years) of the property’s depreciable cost basis.
The initial cost basis is how the total cost you paid to buy the property — purchase price, closing costs, initial repairs and/or rehab or renovation. It is the “book value” of the property.
To discover your depreciable cost basis, subtract the value of the land. Land cannot be depreciated because it isn’t considered subject to wear-and-tear.
Every year, if you deduct depreciation, you must subtract that depreciation from the cost basis to produce an adjusted cost basis.
Let’s say you bought a rental property for $600,000 all in (purchase price, closing costs, rehab, etc.) and according to the tax assessment, roughly 16.6% of that property’s value is in the land. That means the initial cost basis is $600,000, the depreciable cost basis is $500,000.
In the first year, you can write $18,180 (3.636% of $500k) in depreciation off your taxes. Nice! You should owe a lot less, or get a much bigger refund, in April. Your adjusted cost basis is now $581,820. You can do this for the next 27 years, until the adjusted cost basis is $0.
There’s a downside to depreciation. If you sell the property for more than you paid for it instead of less (every real estate investor’s goal) you are subject to a rule called depreciation recapture.
Basically, the profit above the initial cost basis is taxed as a capital gain. However, the profit over the adjusted cost basis (adjusted down for depreciation, that is) is taxed as ordinary income, usually a higher rate.
Fortunately, depreciation recapture is usually capped at 25%. If your profit is high enough, you won’t be too upset that you settled for the short-term benefit of lowering your annual tax liability.
Nevertheless, consult with your CPA. You are allowed to write off less depreciation than the maximum allowed by the schedule. You are even allowed to write off no depreciation at all. In certain circumstances, that might be the better strategy.
If you want to put the power of depreciation to work in your tax and investing strategy, reach out to MartelTurnkey! We help both beginner and seasoned investors — in state and out-of-state — to build wealth, create cash flow, and reduce their tax burdens with turnkey rental property in Cleveland, Memphis, St. Louis, and Detroit.