Is Depreciation Really A Benefit to Rental Investor Or a Trap

[Pesi S.]

Hello,

Depreciation is touted as one of the big benefits of buying investment real estate (rentals) . I am not able to understand the benefit of taking depreciation on a rental property. On one hand IRS rules force you to take the depreciation every year and on the other hand when you sell the property all the depreciation you took gets added to your income and you get taxed at 25%. So what is the big benefit here ?. In fact its a nasty surprise to pay a huge tax bill.  if you  never sell and pass it on to your heirs as step up then it might benefit but if someone wants to just sell and get out of rental business (not do a 1031) it seems like a huge trap.

e.g. Lets say I buy a rental property for $100K and building is valued at $80K. Lets say I take 2K depreciation every year for 10 years. So on total of $20000 of accumulated depreciation over 10 years I save tax = 20000*25/100 = $5000 (say I am in 25% tax bracket). 

Now when I sell the property, the $20000 in accumulated depreciation gets added to my income and I now have to pay tax of 20000*25/100 = $5000 tax on it (25% tax bracket). So whatever $5000 I saved over 10 years in one go I am asked to pay back. Unless I am missing something, what did I really gain here ? A big chunk of your profit will go into paying this if one hasnt kept aside money every year to pay back this depreciation.

Appreciate if anyone can provide insights on this.

Thank you

[Greg Scott]

You are missing three key points

1) The time value of money.  Would you rather pay $1 today or $1.5 at some point on the future?  What if that some point was 10 years or 20 years or 30 years

2) Focus on growth, not one and done.  If all you do is buy one property and later sell it, you have the scenario you outlined.  But what if you buy one property and then later buy another, then another, then later sell the first one and then buy two more.  If you are growing your net worth and growing your assets, you can continually kick the can down the road

3) You can literally never pay the taxes.  Once you die, all those recaptured depreciation taxes are wiped out and your heirs inherit the property at a stepped up basis.  So, if you do it right, you never pay any taxes.