Real Estate Depreciation

[Patrick Gilbert]

So I understand the concept of depreciation - appreciating asset that degrades ("depreciates") over 27.5 years so you get to take a loss on taxes. My question is: how is that depreciation number determined, specifically when using the BRRRR method? Is it determined via initial purchase price or can you use ARV appraised value? It could obviously vary greatly depending on the amount of rehab needed. Thank you!

[Joe Splitrock]

Quote from @Patrick Gilbert:

So I understand the concept of depreciation - appreciating asset that degrades ("depreciates") over 27.5 years so you get to take a loss on taxes. My question is: how is that depreciation number determined, specifically when using the BRRRR method? Is it determined via initial purchase price or can you use ARV appraised value? It could obviously vary greatly depending on the amount of rehab needed. Thank you!

Depreciation is based on purchase price - land value + capital improvements (actual cost). ARV or appraisal has nothing to do with it. All business costs are based on actual expense. This is important because your own labor (aka sweat equity) cannot be claimed.

Depreciation is actually the IRS telling you that "you can't take the full cost year one because the item is too expensive". It is basically the IRS slowing your expense realization. 

I would work with a tax professional to setup your depreciation schedules. There are specific things that need to be depreciated versus claimed in a given year. Even within depreciation there are different terms, so the 27.5 years applies to some items, shorter for others, bonus depreciation for others. There is also diminimis that may come into play.

Final point, you may not have a loss on your taxes. Depreciation reduces your taxable income, but it often doesn't result in a loss. Usually it will offset a good chuck of income and early years are often a loss. Later years, depreciation stays the same and rents increase, so plan on taxes. It is hard to not have taxable income if you are successful in real estate.