Is Depreciation Worth Anything?

Question

I see a lot of investors get excited about depreciation because property values usually go up, but investors can report they went down on their taxes.

I am skeptical this is actually an advantage.

For example, commercial real estate depreciates over 39 years. It doesn't seem crazy to me that a building would wear down to salvage value over four decades if not maintained.

Property values appreciate because of inflation, increased demand, and value-add and these increase the price more than the property wear-down decreases the price.

But because this happens at the same time, it is hard to see the property would have appreciated even more if not for the wear-down, and therefore the depreciation is just neutral.

Depreciation can't be applied to W2 income so does not allow a tax arbitrage, appreciation from inflation is neutral because everything else is more expensive too, and only the value-add items are allowed to be depreciated on a fresh schedule, plus there is depreciation recapture at the end.

So I don't see any tax hacks or loopholes in this. Just seems like a fair way to account for building wear-down and people get confused easily because depreciation happens by itself and early, whereas the property value is mixed together at the same time.

What do you guys think?

Natalie Kolodij · Answer

Just here to add a few comments:

1. Depreciation isn't optional. So you have to take it either way. Otherwise when you sell you're still taxed as though you did - and you ALSO didn't get the benefit.

2. Even if you can't utilize losses created by depreciation this year you can use them eventually. Most typically, when you sell the asset. So if you have a $10k annual loss you can't offset w2 income with...and sell the rental after owning 10 years...thats $100k of losses you get to use to reduce your gain when you sell it.

3. It does re-set when a taxable event (sale). So If you own a property for 20 of the 27.5 years and sell it to a new owner...that new owner gets to start over with a new 27.5 year life cycle at the price they paid.

4. Many people have income under $100k (allow losses of $25k a year), have Short-Term rentals which are often passive and allow losses, or they or their spouse qualify as a RE professional which would allow large amounts of rental losses (typically generated by accelerated deprecaition) to offset their other income sources.

Bill B. · Answer

The property doesn’t lose $400k in value though. You find me ANY lived in home that was $500k 27 years ago that you can buy today for $100k. The average home in America is 39 years old, are you saying the average us home is worth zero?  It’s more likely to be $2million 27 years later. That would be 5-6% annual appreciation.

27 years later you do a 1031 in to 10 million worth of properties with 20% down. The 28th year you’re depreciating 360k per year over 27 years. If you did It right you’ve put $100k down on that first property (20%) to own those properties. So if you didn’t start until 25 years old, and you were to scared to do it more than once.you retire at 52 and live pretty much tax free.

I started at 35, bought 12 and retired at 40.  I didn’t pay any taxes for the first 10 years until I had paid them all off and just made too much darn money. If I had kept buying more I woulda have made more and paid less taxes, but my lifestyle is petty simple and $20k/mo is overkill for a guy with no kids.

Ps. I did this before bigger pockets, with a community college 2 year degree, and never making more than $60k/year at a w2. If I can do it, “anybody” can do it today. Interest rates weren’t quite as high but I averages about 5.75-6.25% when I was buying m

Bill B. · Answer

You’re “double dipping”. You take the depreciation AND you write off the repairs/cap-ex.

You buy a house for let’s say $500k. Over 27.5 years you get “killed with maintenance” and spend $100k. You depreciate $400k for the building (not the land) and you expense the $100k in repairs. So you lowered your income $500k saving about $100k in taxes, maybe $150k if your state has income taxes. Then “luckily” you finally die leaving the property to your kids and they never pay the depreciation back.

Ps. If you have an average income you can take a $25k/year loss from your rentals depreciation. If not, it just piles up waiting for you to stop working. But if you do have a high income the good news is the rental income isn’t piling on top getting taxed at the highest rate. In the example above you can profit $13k/year tax free. And that’s per property if you have 10, you’re making $130k/year tax free.

It’s not supposed to be THE reason you invest in real estate, it’s one of the reasons. To me the important ones are appreciation, then principle pay down, then depreciation, stability/diversification and then cashflow. For others something else is important. Or the order is different.

Bill B. · Answer

@Shafi Noss

Sorry. I missed an important part of your reply. YES. The depreciation schedule does refresh every time the property is sold. If you buy a 200 year old property on the east coast. It might have been depreciated to zero 5 or 6 times already. You get a new 27.5 years based on your $500k purchase price. Even if the original purchase price might have been less than $500. (Not $500k, $500)

Ana Garcia · Answer

@Shafi Noss

As a tax professional I can tell you depreciation is an amazing deduction, for the simple fact that it reduces your rental income even when no cash flow goes out and the real estate actually appreciates in value over time, as you mentioned.

The fact that you cannot deduct losses against W2 income (in cases when your income is above a certain threshold) can happen with any other expense, not just depreciation. To provide an example, let's pretend that your tax accountant forgot to include depreciation on your tax return, but you had a lot of repairs that get you to a rental loss, you still will not be able to deduct the loss against W2 income if your income is above a certain threshold.

However, things are never black and white in tax law. This is where tax planning comes into play, so that taxpayers can actually benefit from many tax deductions and loopholes that, with proper and proactive tax planning, can be applied, putting more money in the investors hands.

I hope this is helpful!

Ana B. Garcia, CPA, MSA, CTP

Reed Rickenbach · Answer

If you had a strong income year as a real estate professional and can alleviate your tax burden NOW while the physical structure will depreciate over the next 40 years, it can be very beneficial. Assuming you'll invest the difference, you're better off having the cash in hand now and earning a return on the tax savings.

Also, if you're using leverage, it is not a 1-to-1 comparison. Your cash out of pocket is only 15- 30% of the value typically, but you're depreciating the full basis of the structure. This applies to your comment about inflation being neutral as well - leveraging will greatly increase the value of inflation vs. your cash investment assuming you're getting 65-85% LTV financing.

John McKee · Answer

Depreciation (not including bonus deprecition)  is neither an advantage or disadvantage it's just an accounting that you have to take.  I agree that the depreciation you can take on a property is overhyped as an advantage.  As an investor I get more excited about writing off all that interest on the loan.

Bill B. · Answer

If you believe that then you darn well better be a renter your entire life. Because if it’s a bad deal for landlords who can write depreciation off their taxes it’s a horribly bad deal for owner occupants who can not.

It’s a bad year in Vegas when I spend $2,000/year on a property. So maybe a $500k property takes $40k in repairs over 27 years. I get to write off $400k in depreciation and the $40k in repairs. That means I’m ahead $100k. The home owner is out $40k. So obviously owning your home is much worse than owning rentals.

If you don’t own rentals you should be a renter. Heck, I know some landlords who are renters.

Ps. As stated above, it’s not an option so it doesn’t matter if you like it. Consider it a negative if you want. Rentals are still the easiest path to financial freedom on the planet for the average person. Good luck whichever path you choose.

Kevin Sobilo · Answer

@Shafi Noss, I'm glad you recognize things like the 1031 and basis reset upon death because those are HUGE benefits and to many people a loophole that will allow them to NEVER recapture that depreciation!

The depreciation on a year to year basis simply gives you a nice boost because of the time value of money. So, the money you don't pay in taxes this year you are able to put back into use and it then produces you MORE return. If you do that year after year those deferred taxes allow your returns to grow and grow. It is similar to a traditional 401k or IRA where the taxes are deferred. Not paying the tax now allows the money to grow a lot more for you.

Nothing is in a vacuum though. So, it is not reasonable or fair to try to analyze the benefits without considering strategies like 1031s and basis resets upon death.

Carlos Ptriawan · Answer

I agree with you, I don't invest in REI because of the tax advantage, I don't see the depreciation as advantage at all. It's just one of the "nice to have".

Is Depreciation Worth Anything?

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