REAL ESTATE INVESTMENTS
What is Depreciation?
Depreciation is simply the taking of a fictitious expense each year which when added up should equal the cost of replacing the item depreciated. There are many methods of depreciation depending upon the allowable tax code rules then in effect, the accounting practices then in effect, and the nature of the item being depreciated. This article does not address Section 179 issues wherein certain “large ticket” items can be expensed in a single year.
Generally speaking, any item in excess of the “capitalized amount” is depreciated. This floor limit amount is usually given to you by your accountant.
The most common depreciation seen in real estate investing is the depreciation of the improvements – the buildings. This is calculated by taking the value of the total property and subtracting the value of the land and dividing by a certain number of years. Currently, for residential properties it is 27.5 years and for commercial properties it is 39 years. This number applies to how the property is being used – thus a 200 unit multifamily building would be considered residential.
For example: The price paid for a residential rental home was $250,000.00 and the land is determined to be 20% of that amount. Thus the depreciation would be calculated as 80% times 250,000 which is $200,000 divided by 27.5 which is $7,272 per year. Generally - this $7,272 figure becomes a tax deduction related to this hypothetical investment property.
It is possible to depreciate components of an investment property as well, such as the HVAC system over perhaps 7 or 10 years. Your accountant is a vital resource when determining the components and the depreciation schedules.
Depreciation is generally NOT used in the calculations for value or return, but basically used to calculate the tax impact and the after-tax cash flow.
Finally, there are "re capture" rules wherein depreciation expenses taken will be recaptured upon the sale of the investment property. Currently the general rate for recapture is 25% - but as many portions of the tax code - it is subject to changes. Your accountant again becomes a vital resource in this regard.
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