Tony Robinson, one of our local investors, wrote the following article on the value of depreciating your properties. Depreciation gives you HUGE tax advantages which is a large income stream that not everyone considers when they’re contemplating becoming a landlord.
I hope the following explains some of the advantages you may not have considered. If you have any questions about depreciating properties, please add them here to the comments section so we can clear up any confusions.
Here’s a synopsis of Tony’s article:
Many of us using the long term hold strategy fail to capitalize on one of the true benefits of owning real estate. Though the benefits are many, I find the ability to offset income by maximizing depreciation to be the most valuable of all. Did you know that depreciation allowances offset the gross income received on real estate?
Let me explain. The IRS extends the benefit of depreciation to owners of rental property. Here, the government is actually giving us an incentive to own real estate! The depreciation factor for single family residential property is 27.5 years. This means that you can take depreciation on the “dwelling” spread out over 27.5 years.
An example of how depreciation works is as follows:
You buy a house for $100,000.00; the dwelling value is $80,000.00 and the land is $20,000.00. You cannot depreciate the land, however you factor depreciation on the dwelling by dividing the dwelling value by 27.5 (80,000 ÷ 27.5 = $2,909.09). In this example, that gives you a depreciation allowance of $2,909.00 per year.
If you don’t know how sweet this is let me explain. This means that if you rented the property for $800.00 per month and your mortgage was say, $600.00 per month, you would have a positive monthly cash flow of $200.00 or $2,400.00 per year of income. Now factor in that the IRS allows the depreciation deduction, and your income is now offset by the depreciation expense (2400.00 – 2,909.00 = -509.00).
This means that, for tax purposes, you lost $509.00 on this property. Now– you and I know that this is a “paper loss” only, as you actually made $2,400.00. The sweet part is that although you are depreciating the property on paper you are, if you purchased correctly, receiving the added benefit of “appreciation” as the value of the property is increasing over time. How sweet is that?
And, you can maximize the depreciation for your long term holds by doing what’s called “componentized” depreciation. This allows you to break out certain components of the property and depreciate them separately, i.e. the carpet may be componentized and broken out as personal property which can be depreciated over 5 years. This would also apply to appliances, HVAC, roof, etc. You might want to get with your accountant/CPA to see how to implement this into your long term hold business structure.
One other point in the example illustrated above–the depreciation put you at a loss (on paper) before you even started to deduct your normal business expenses such as maintenance, cleaning, travel, supplies, interest, taxes—my gosh!!!! It goes on and on!
Go Buy a House!!!