How Depreciation Tax Savings Work for Smart Real Estate Investors

It’s tax time, again…

Yes! It’s almost that time of year where we give a BIG portion of our hard-earned money to the government. But, unfortunately, depending on your tax bracket, business or situation, you’ll likely be giving the government upwards of 50% of your taxable income.

Usually, taxpayers find little things here and there to reduce their taxes, like interest payments on loans or milage on their business vehicles. But, while these various tax deductions help, they don’t put a big dent in overall tax liability. This is where income-producing real estate comes in.

What is real estate depreciation?

The quick definition for real estate depreciation is that it allows you to deduct the costs from your taxes of buying and improving a property over its useful life. This means that depreciation will enable you to lower your taxable income.

The extended version is that physical assets, like buildings, suffer from physical depreciation that over time reduces their economic value. Because these buildings will eventually be replaced, tax laws were created to allow investment in improvements to be recovered before income produced from the improvement is taxed.

This means the investor may take a deduction for capital recovery (depreciation) from net operating income prior to the determination of taxable income.

That’s nice, but how does it work for me?

To start, I’ll give you a simplified example of how it can apply to you. Since I manage a fund at Projected Capital that focuses on multifamily assets, we’ll use that asset type for this example.

Let’s say you’ve invested into a fund or rental property that costs $1,000,000. I know that’s a lot of money, but it’s a manageable number. For multifamily assets, a million dollars really isn’t a lot.

But, if you want to know what the numbers are per $100,000, all you have to do is divide these numbers by 10. That will make it easy for you if you’re invested in something like single-family rentals.

To continue, let’s also say the tax assessor’s estimate of the land is $300,000, and the building is $700,000. Because our example uses multifamily, it’s considered residential for depreciation purposes, which means we get to depreciate it for 27.5 years.

Now we have to plug in the numbers to get our “loss” for each year. We take our building’s value and divide that by its useful life (a.k.a. depreciable life). $700,000 / 27.5 years = $25,454.54.

This implies that there would be a $25,454.54 “loss” for tax purposes each year, which is impressive! If you’ve invested into a fund, and it’s structured in such a way that it passes these benefits to its investors, then you will get these tax benefits as well.

I’d like to also clarify a few things that you may have had questions about the above information.

1. 1. Real estate appreciates in value, and depreciation is a separate thing on its own.
2. 2. Depreciation should be considered a phantom expense as it’s not a loss coming out of your pocket. When people hear the word loss, they immediately think of something that costs them. However, when we’re talking about taxes, that “loss” is considered an expense, which reduces your tax liability. But, again, that expense isn’t something that comes out of your pocket.
3. 3. When we talk about depreciation, it only works for “improvements,” which essentially means the building and not the land.
4. 4. When doing your calculations, know that different asset types have other depreciable years.

Are we done yet?

Yes, I know it’s math, and there are a lot of different nuances that go into how to depreciate properties. However, this article aims to quickly show you the tax savings built into the U.S. tax code, and why you should be taking advantage of these benefits.

If you’re paying a lot of taxes, I would suggest that you look at investing in real estate if you haven’t already. However, if this seems too complex, you can also passively invest in real estate by finding a fund or syndication to invest in.

Either way, I’m sure you’d rather invest and have readily available tax benefits than give away your money to the government to spend on their agenda.

Disclaimer

Please note that this example is elementary and straightforward. There are also different methods for depreciation not discussed in this article, such as accelerated or straight line. This information, in any fashion, should not be viewed as legal, investment, or tax advice. Prospective investors should consult with a tax or legal adviser before making any investment decision.