Straight-line Depreciation in Real Estate

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Real estate investment has some distinct advantages over investing in the stock market. There are some regular, common tax deductions available to investors, but there are also others, like depreciation, that you might not know about. Straight-line depreciation is the depreciation of real property in equal amounts over a dedicated lifespan of the property that's allowed for tax purposes.

Some rules are specific, such as for the depreciation of rental properties, and specifically single-family, rent-ready rental homes or condos. They don't apply to properties you intend to fix up and repair, then rent.

A Simple Example of Straight-Line Depreciation

If a certain property that cost $180,000 can be depreciated using a tax life of 27.5 years, you would divide $180,000 by 27.5 to yield a straight-line equal amount of $6,545 in depreciation each year. That's your annual depreciation deduction, and you didn't spend any extra dimes on costs to get it. It's yours simply for investing in the first place.

This assumes that the property is rented out. The Internal Revenue Service sets a recovery period for residential rental property of 27.5 years based on using the general depreciation system of the modified accelerated cost recovery system (MACRS).

This is a most basic, simple example for illustrative purposes.

Other Factors Involved in Calculations

Of course, there are other rules and figures that you must also include in the calculation.

  • You would actually begin with your "basis" in the property, not necessarily the exact purchase price. There will probably be some measure of difference. You can arrive at your basis by adding your closing costs, such as legal fees, any transfer taxes, title insurance, appraisals, and recording fees.

Check with an accountant for allowable closing costs. Certain expenses, such as mortgage insurance premiums, are not included.

  • You must next subtract the realistic land value of your rental property because land doesn't depreciate. Use the fair market value of each—the building and the land—as of your date of purchase. You can depreciate 85% of your basis if the building's value represents 85% of that.

Due Diligence and Buying Right

You do not want to consider this potential deduction when you're evaluating a rental home for investment. You can keep in mind how great you'll do with deductions when you do the final number-crunching, but you only want to look at the basics and concentrate on cash flow when you're first getting into the deal.

This means asking these key questions:

  • Can you buy the property at a price that's below current market value, locking in a profit in equity at the closing table?
  • Will the current market and competitive environment support rent that will pay your expenses and still leave a nice monthly profit as cash flow that you can take to the bank?
  • Have you allowed for some vacancy and credit losses?
  • Do you have all your expenses either nailed down or closely estimated?

Don't neglect to include advertising, management costs, repairs, property taxes, insurance, and any utilities you'll be paying, such as water and sewer.

Determine these answers before you buy the property. Everything else is gravy. 

Deducting Expenses

Your expenses are also deductible against your income for tax purposes. You can deduct mortgage interest as well, although it isn't considered an operating expense.

You can't wholly and immediately deduct major repairs, however, such as equipment replacement. Many of these costs must be depreciated, but you at least get to deduct a portion of the cost each year for a period of time.

Depreciation Recapture

The IRS will eventually take back some of your tax savings when you sell the property. You'll have to report as income the difference between your basis and your sales price in the year you make the sale.

Growth Through 1031 Exchange

You can only use a 1031 exchange if you decide to grow your portfolio by selling properties profitably and immediately plowing that money into other, new properties.

Consult an accountant because the procedure is complicated and the rules are strict. The investor is pretty much hands-off. A third party must step in to take in the proceeds of the sale and disburse the funds to buy the new property.

You won't have to pay capital gains tax on the sale of the property in the year it's sold if this is done properly. You can defer capital gains tax until you ultimately sell the property and fail to roll the proceeds over into another one.