Depreciation of a Rental Property
If you came to this article in a search, it is part of our Rental Property Investment Analysis. Start there to walk through a detailed analysis of a sample property. However, here is an overview of depreciation of a rental property, and why investors benefit tax-wise.
In our series on Rental Property Investment Returns, we're using an example fourplex as our investment. You can get the purchase details here, however, remember that it was a $325,000 purchase of a fourplex for rental of all four units full time.
Always check out all tax issues thoroughly with a tax accounting professional, however, the IRS generally will allow us to depreciate the value of the structure on this property over a period of 27 & 1/2 years. This is the logical treatment of the fact that buildings do wear out over time, or become obsolete due to their older features no longer in demand.
So, we have a property that is generating $15,192 per year in positive cash flow, but now we can offset some of that income for taxes. We depreciate the building by deducting out the value of the land and dividing the building value by 27.5 years for annual depreciation. The depreciation calculation looks like this:
- Purchase price - Land Value = Building Value.
- Building Value / 27.5 = Annual allowable depreciation deduction.
For our example fourplex, we'll assume that the value of the half-acre on which it sits is $80,000. Now let's look at our calculation:
- $325,000 - $80,000 = $245,000 Building Value.
- $245,000 / 27.5 years = $8909 per year in depreciation.
Without taking any other property tax or mortgage interest deductions into account, we've already reduced our taxable income. As we want to look at tax aspects of our property, we're adding back the principal and interest in the mortgage payments we subtracted for the cash flow calculation. Thus our $15,192 cash flow goes back up to $34,908.
$15,192 + $23,316 - $3600 taxes & insurance = $34,908. This is the potential tax liability for the direct rental income minus taxes, vacancy loss, insurance, repairs and direct expenses. We'll look later at other deductions. But here is how the depreciation backs out.
- $34,908 - $8909 depreciation = $25,999.
Remember that we didn't spend any money to realize this deduction. And we still have other deductions to take. The payment isn't in the calculation yet, as we have to break out interest from equity. It isn't a totally free ride on this deduction either. When you sell the property, you will have to take these depreciation deductions into account when calculating capital gains for taxes. However, there are ways to overcome those taxes as well with a 1031 Exchange.
Rental home investing is very popular, especially for new investors or those who want monthly cash flow rather than big short-term profit boosts from wholesaling or fix & flip investing. Depending on your age and time to retirement, rental investing can accomplish a lot for you:
- Nearing retirement - As you near retirement and begin to calculate monthly income from the current stock market and other investments, you may find that there isn't a very high rate of return coming your way from dividends or interest. Reallocating your assets, you could sell stocks or bonds and move money into rental homes. There is less risk if you invest wisely, and returns are higher. You'll have more monthly income to fund your looming retirement.
- Young, but planning - This is really where you can start building a really nice retirement almost anywhere you want and live a great lifestyle. Begin buying properties as rentals, and you'll start gaining equity as they appreciate and you pay down mortgages. You can take those profits with a 1031 Exchange and roll them into more rentals, maybe higher priced homes rather than more of them. You'll avoid capital gains in rolling up if you do it right.
Rental property investing will always be a great way to invest, as there will always be renters. The housing and mortgage crash that began in late 2006 shows us how rental property has become good investment practice. All of those people who lost their homes to foreclosure became renters while they rebuilt their credit and saved for down payments.
Younger buyers pretty much left the market for years after seeing their older relatives lose their homes or equity. They delivered a huge demand for rentals. Rental home investment is resistant to negative effects of interest rate increases and inflation. It's a great way to grow your wealth.