Depreciation in Real Estate
Depreciation is a measurement of the decline in asset value over time until the value of the asset becomes zero, or the property is sold, whichever comes first. Depreciation can happen to virtually any fixed asset, including appliances, office equipment, computers, machinery, buildings, structure improvement, and so on.
In Real Estate you can use depreciation to lower your taxable income
How does it work ?
Let’s assume you have an investment property: You paid $600,000.
The value on the tax record for the land is $150,000 and the Improvement ( building ) is at $300,000
OK, I am simplifying the number here. You cannot depreciate the land so you have to figure out a fair value for the building.
So we can see that the land is worth 1/2 the entire property value. So we can assume that $400,000 is a reasonable value for the building. Now if the building is residential you can depreciate the property in 27 and 1/2 years – If the building is commercial you can depreciate over 39 years.
So assuming the property we bought is residential we have $400,000 / 27.5 = $14,545
On your income tax, you deduct $14,545 for the year. You pocket the money and you do not pay taxes on it at least till you sell the property. Be careful that depreciation accumulates and eventually you will have to pay taxes on that amount unless:
1) If you do a 1031 exchange you can postpone further the payment and maybe you never pay it. The 1031 exchange is a procedure that allows the owner of investment property to sell it and buy like-kind property ( basically a property with similar characteristics) deferring the payment of capital gains tax.
2) If your kids inherit the property they will not have to pay the accumulated depreciation and instead the depreciation will reset … the catch is they do have to inherit…..
3) Depreciation is a mandatory deduction. The IRS will not come after you if you do not take it but will assume at the time of sale that you took full advantage of the depreciation rule and you will have to pay taxes on it whether you took it or not.
Also, don’t forget you will be able to depreciate also Appliances for example
I leave this calculation to Quickbooks but the theory is the same for all classes, for example, the IRS considers appliances to have a lifespan of five years.
Let see if we can calculate the yearly depreciation
Refrigerator paid $1200
Value after 5 years $200
Depreciated Value $1000 = $200 per year depreciation
NOTE: Always double-check this information with an accountant and possibly an attorney