Depreciation and Taxes

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Taxes are a major consideration in any investment decision because it's not how much you make, it's how much you get to keep. Fortunately, tax treatment for investment real estate actually increases your effective return. This article will demonstrate how. Also, we will explain why we do not include this in our return calculations even though the mandated depreciation on real estate effectively increases return.

With investment real estate, in addition to deducting all related business expenses, you are effectively required to depreciate improvements. How does depreciation work?

First, a definition of depreciation: "Depreciation is the reduction in the value of an asset with the passage of time, due to wear and tear." For example, if you buy a drill and use it, over time the drill wears out and at some point in the future you will have to replace it. Effectively, you are losing a percentage of the original value of the drill each year the drill is in service. The IRS specifies the "useful life" of many items used in business including drills, office furniture and real estate.

For example, the IRS guidelines state that the useful life of office furniture is 7 years. This means that you can deduct 1/7th of the purchase price of the furniture per year as an expense on your taxes. So, if you paid $700 for a desk, over each of the following 7 years you can deduct $100 from your taxable income.

The only significant difference between depreciating office furniture and real estate is that you can only depreciate real estate "improvements" (structures and such) and the useful life is 27.5 years for most types of real estate. The concept is that land never wears out so it is not depreciable. How does this work in practice?

For example, suppose you paid $250,000 for a property, which includes structures and land. If we assume 80% (a common assumption) of the purchase price is for the structures (the "Improvements"), you would calculate the annual depreciation as follows: $250,000 x 80% / 27.5 or $9,090/Yr. year.

Below is an example property:

  • Purchase price: $250,000
  • Rent: $1,400/Mo. or $16,800/Yr
  • Management fee (8% of Collected Rent): $1,344/Yr
  • Property taxes: $1,250/Yr
  • Landlord insurance: $400/Yr
  • Debt service (30Yr, 25% Down, 5%): $1,000/Mo or $12,000/Yr
  • Interest portion of debt service: $9,312/Yr (only the interest is deductible, the principal portion is not deductible)
  • Annual depreciation = ($250,000 x 80%) / 27.5 = $9,090/Yr

Let's look at how the IRS sees the property and your actual income from the property.

Item IRS View Actual Income
Income:
Rent 16800 16800
Expenses:
Management -1344 -1344
Property Taxes -1250 -1250
Insurance -400 -400
Debt Interest/Payment -9312 -12000
Depreciation -9090 N/A
Gain/Loss -4596 1806

So, to the IRS your property lost $4596, which, depending on your personal tax situation, would shield $4596 of your other income from any taxes. Yet in reality, you deposited $1,806 in your bank account.

Let's take this a step further. Suppose your federal marginal income tax rate is 30%. To estimate the effective income from the property the calculation would be: $4596 x 30% + $1806 or $3,184. Tax treatment for investment real estate increases your return because the "loss" offsets other income. In this example, you would have had to earn $3,184 to have $1,806 after you paid taxes.

Also, even if you choose not to use depreciation, the IRS will tax the property when you sell it as if you had depreciated the property. There really is no option. This is why we say that depreciation is manditory.

A frequent question for us is, "If depreciation is mandatory, why don't you include it in your return calculations?" Many people do so in order to make returns appear more attractive. However, our goal is to provide our clients with a realistic estimate of what they will actually see in their bank accounts, after all expenses including reasonable assumptions for vacancy and maintenance. Based on calculations we've performed, tax advantages on average increase return by about 3%. Maintenance and vacancy on average decrease return by about 1.5%. So tax advantages more than cover the cost of maintenance and vacancy. By not including tax benefits in our return calculations, we are able to provide a conservative estimate of realized cash flow that effectively includes tax advantages and reasonable maintenance and vacancy costs.