Simple depreciation explaination

[Chris Martin]

This was taken from a PM to a colleague.... After writing it up, I figured I'd put it here for your entertainment;)

About the tax comment in my post...

This is a simple example. The numbers are to show the point. Don't get caught up in the small details.

Buy a house to rent out. $100K purchase. The IRS allows you to deduct a non-cash expense for depreciation, because houses (like all capital equipment) wear out. You depreciate the improvement (the house) not the land. For that $100K, say your house is $82.5K and land is $17.5K based on your property card from the county appraiser's office. You rent the house monthly for $1,200 and have $500 actual expenses. So you "make" $700 per month... but you have a mortgage, and interest averages $450 monthly. So your net is (roughly) $250 per month or $3,000! Do you pay tax on that $3,000? Not today. Here's why.

As I said earlier, capital equipment that is used to make money for a business wears out. Cars, trucks, chain saws, ... houses. The IRS allows you to account for, via a deduction in the current tax year, the "wearing out" of your equipment. Now here's the key. The algorithm the IRS uses allows for houses to "wear out" in 27.5 years. So, numbers wise, your $82.5K equipment (house) wears out $3,000 every year. ($82,500/27.5) And that $3,000 is expensed, meaning it's as if you wrote a check to someone for a property service... except you don't write a check. It's a non-cash, bookkeeping expense.

So the annual after depreciation income is $0. You have $3,000 more in your checking account, but no tax liability(*). There are other ways to manage tax liability beyond the first year. You can research Estate Planning methods and stuff like the 1031 exchange process on BiggerPockets or with your financial planner.


(*) No current tax liability. The IRS may recapture later unless you take other action.