Real estate investors frequently cite depreciation as one of the major benefits of owning investment real estate. However, if you’re unfamiliar with real estate investing or accounting, you may have questions such as “what is depreciation?” and “what are the benefits?” We hope that the below sections provide insight into depreciation and its benefits.
What is depreciation?
Depreciation is an accounting expense used to allocate the costs of acquiring certain tangible or physical property over their useful accounting life. Business expenses are deductible against revenues to reduce taxable income based on their useful accounting life. For expenses that lack longevity, such as office supplies like pens and paper, the full expense can be deducted in the purchase year.
However, for capital assets such as an investment property, the investor cannot deduct the entire cost of the purchase against their revenues in the purchase year. Instead, depreciation expenses the costs over the asset’s useful accounting life. In the case of real estate, the accounting life depends on the type of property, with residential rental properties normally depreciating over 27.5 years. This means that 3.6% of the building’s value at purchase is deductible as an expense each year, resulting in the total value being depreciated at the end of the 27.5-year period.
What can I depreciate?
Real estate investors can only depreciate the value of the building. In the case of residential real estate investing, this means only the value of the home can be depreciated – land value cannot be depreciated. As such, you will need to determine the value of the building for tax purposes.
What are the benefits?
Depreciation is beneficial because it is a non-cash expense. This means that it’s an expense that appears on the profit and loss statement, resulting in lower net income, but doesn’t impact your cash flows. As such, your taxable net income is reduced while your cash flows remain elevated, meaning you pay less tax on the same cash inflow. The amount of tax you save is relative to your marginal tax brackets. If you have $5,000 of depreciation expense in the year and you have more than $5,000 of taxable earnings taxable at the 22% marginal tax bracket, the depreciation deduction will reduce your tax bill by $1,100 ($5,000 x 22%).
Real Estate Lawyers in Rhode Island, Massachusetts, and Connecticut
Depreciation is a powerful tool to minimize real estate investors’ tax burden. However, real estate and tax laws are complicated and nebulous. As a result, real estate investors recommend working with a skilled lawyer and accountant to minimize risks and maximize cash flow.
At Palumbo Law, we represent real estate investors and businesses in all matters of real estate, including development and acquisition, leasing and dispute resolution, and sales and 1031 exchanges. If you have questions relating to real estate in Rhode Island, Massachusetts, or Connecticut, please contact our office to set up a consultation or complete the contact form.