Understanding Tax depreciation

[Jaco Braja]

Hello guys, I am new to investing.

I keep hearing about tax depreciation, but I don’t understand exactly how that works.

Can someone explain that please or give an example.

Appreciate it!

[Ryan Elblein]

Hi Jaco!

When you buy a property the tax law allows you to deduct what you paid for that property over a period of time. It’s easier if I give you an example. Let’s say you bought a single family home for $500,000. Of that $500,000, $100,000 is attributed to the land value and the other $400,000 is attributed to the building. Land is not depreciable under the tax code so you can’t take a deduction for the $100,000 land value until you sell the property. However, the house itself is deductible as residential property over 27.5 years. This means that you will be able to take a little bit of depreciation from the $400,000 building value over the next 27.5 years until the entire $400,000 value has been depreciated. 

One thing to keep in mind though is that as the property is depreciated it, you will have less basis in the property if you sell it. To continue the example, let’s say you went to sell the property and had taken $100,000 in depreciation expenses over the years. Now you have a basis in the building of $300,000 and $100,000 of basis in the land. If you sell that home for $750,000, you will potentially have a gain of $350,000. ($750,000 less the $400,000 in basis you have left). 

It is important to note that this is a very simplified example and there are more factors involved in calculating your depreciation and your gain on sale but this example was just to describe how depreciation works. 

Does this make sense? If not let me know and I will try to explain further.