DEPRECIATION IS ONE OF THE TOP BENEFITS OF INVESTING IN REAL ESTATE.
Rental properties are made up of two components. There’s the physical home structure and the land underneath it. The entire property appreciates because there’s a limited supply of land and housing and increasing demand for it.
Everyone knows that things break in a home. Even the best maintained homes eventually have parts that need to be replaced, or faded paint that could use a new coat. Depreciation is a phantom expense. You don’t actually spend any money, but you get an additional tax deduction.
Your rental property generates profit, and then you’re allowed to count a depreciation expense to lower your taxable income even further. You’re allowed to do this even though you didn’t actually spend any money on this expense.
What is depreciation for rental properties?
The IRS recognizes that physical structures don’t last forever. To recognize that properties wear down over time, they let you count depreciation as an expense against your income.
For tax purposes, a rental property has a “useful life” of 27.5 years. In theory, after the entire property is depreciated it would have 0 value left. Obviously this is just an accounting rule and the structure will still have value even after it’s fully depreciated. This depreciation deduction helps investors keep more of the earnings from their rental property.
How does Depreciation Work for You
Rental properties are made up of the housing structure and the land it sits on. Land doesn’t get depreciated because it can be re-developed into something new. The land doesn’t “go bad” if you don’t do maintenance on it each year.
On the other hand, the structure would slowly fall apart if you never did any maintenance to it. Since it has a limited “useful life” you’re allowed to use the depreciation deduction.
Residential real estate is depreciated over 27.5 years. To calculate your deduction, you start by splitting the cost of the property into values for the land and the structure. Then you divide the value of the structure by 27.5. This equates to deducting 3.636% of the structure’s value each year (100%/27.5 = 3.636%).
The best part about the depreciation deduction is that it doesn’t cost you anything! If you have a depreciation expense of $5,000 one year, you didn’t actually spend $5,000. You don’t need to pay that money, you just get to reduce your taxable income by that much for free.
On top of that, you’re really allowed to double dip with depreciation. You deduct depreciation, the theoretical decline in value in the structure as it’s used up. But you also get to deduct the repair and maintenance expense you incur during operations. So you get to use your actual repair expenses and depreciation to lower the amount of taxes you pay, but you only spend money on the real repairs.
Calculating Depreciation: An Example
Let’s assume this is your property’s financials results for a full year.
|Minus Maintenance: – $1,150|
|Minus Insurance: – $1,000|
|Minus Property Tax: – $2,500|
|Minus Marketing: – $500|
|Minus Property Management: – $1,500|
|Equals = NOI: $12,350|
|Minus Interest: – $5,000|
|Equals Cash Flow and Profit: $7,350|
Pretty good! Now you need to pay taxes on the profit. Without depreciation, you’d pay $1,764 if you’re in the 24% tax bracket ($7,350 cash flow multiplied by 24% tax rate = $1,764).
With depreciation, you’re able to deduct part of the purchase price each year. Let’s assume you purchased this property for $200,000. Residential property is depreciated over 27.5 years. $200,000/27.5 gives us an annual depreciation “expense” of $7,273.
Now the end of our profit and loss statement looks like this:
|Minus Interest $5,000|
|Equals Cash Flow and Profit $7,350|
|Minus Depreciation $7,273|
|Equals Taxable Income $77|
Income Tax would only be $18.48 ($77 of taxable income multiplied by 24% tax rate).
We didn’t have to spend any money for the depreciation, but we’re allowed to add an $7,273. We’ve paid only $18.48 in income taxes even though this property generated cash flow of $7,350!
This phantom expense lowered our taxable income but we didn’t need to pay anything for it. Often times the depreciation expense is so large that the taxable income is negative and you don’t pay any extra in income taxes.
How Depreciation Works with Arrived’s Properties
Arrived investors get to benefit from depreciation. Arrived depreciates each of our rental properties, and that depreciation expense is passed on to investors. That means investors get to profit from their rental property and will also minimize their tax bill with this awesome accounting rule.
Usually depreciation has been a piece of the tax code that only wealthy inventors were able to benefit from. With a minimum of only $100, tax efficient real estate investing is more accessible than ever.
Sign up below to Arrived Homes to receive all the tax benefits of depreciation.