Depreciation on a Rental Property

[Nicholas Norris]

Hey Guys!

So i was using an excel spreadsheet to analyze a property that I may purchase this Fall. However, I noticed there was a cell labeled "depreciation" which always comes out as a loss. I tried to research what this was, and I came across a few posts. However, my mind is really not registering what depreciation is and how it affects my end of year profits. I know it has something to do with tax write offs, but I was hoping someone could elaborate on what depreciation is and how it will affect my single family rental. 

My main questions are:

1. Why is depreciation a loss that eats at my profits?

2. Is depreciation on a property required?

Thanks!

[Paul Caputo]

@Nicholas Norris I understand the confusion, in fact I deal with it regularly :) Depreciation is tricky, but once it's explained should all make sense. Depreciation is a "phantom expense" meaning you take it like an expense but you're not actually paying anything out for it. 

1. Depreciation lowers your taxable income and it's only there on paper. It isn't eating your profits, it's actually improving your cash flow by lowering the amount of tax you pay. This is one of the reasons real estate is a great investment. You can have a positive cash flow while showing zero (or negative) taxable income due to depreciation. The key here is taxable income, not actual income. You want taxable income as low as possible and actual income as high as possible.

2. Yes depreciation is required on rental and commercial property. Again it's actually a tax benefit so there's no reason not to take it. Furthermore when you sell the property depreciation is recaptured. You get the benefit because you own the property, when you no longer own it you're no longer entitled to the benefit. The IRS will hit you for depreciation recapture when you sell whether you took it or not, so it's best to take as much as possible. Lots of people get surprised by a big tax bill after selling and not taking depreciation. 

Here's a simple example. Say you have a rental property with a $275,000 depreciable cost basis, that's purchase price less land value. The depreciation schedule for rental property is  27.5 years so in this case you'd have $10,000 depreciation per year. So if your profit per year on the property is $10,000 after all other expenses, the depreciation brings the taxable income down to zero. But you still put that $10,000 in your pocket, you just don't pay any taxes on it. 

Depreciation is my specialty so if you have any other questions or need further explanation just let me know.