Understanding Depreciation – Does Depreciation Mean Less Income

Depreciation? Is that good?

Greetings from the metropolis of Cedar Crest, NM.

Today’s blog talks about depreciation.  Not the ugly type…i.e., “my house just depreciated by 50%.”  No…this is the good type of depreciation that real estate investors love (the real estate “tax loophole”).

By the way, one of my favorite people and friend, Diane Kennedy, has a great site regarding Tax and Accounting information for the small business owner: www.TaxLoopholes.com.

Does Depreciation Mean Less Income?
Understanding depreciation is crucial to knowing the true value of your real estate. Depreciation is an accounting and business term that also applies to real estate. According to investorwords.com, the term depreciation refers to:
1. A reduction to an asset’s value by a non-cash expense like age, obsolescence or wear and tear. Most assets depreciate (lose value) and must be replaced upon termination of their useful lives. Depreciation, as a non-cash expense, increases a company’s cash flow while lowering its reported earnings.
2. A decline in a currency’s value when compared to other currencies.
For our purposes, we need only examine the first definition.

How Does it Really Work?
Accountants treat depreciation is treated as a line item on an income statement. Since depreciation refers to wear and tear and general age, it cannot be applied to the value of the actual land itself. Instead, equipment, buildings and other assets depreciate.

The standard IRS formulas for calculating your depreciation are as follows:

-Residential Income Property (any building with four units or less): Depreciation is applied over a 27.5 year period in equal amounts over each year of the asset’s useful life.
-Commercial Income Property (any other property): Depreciation is applied over a 39 year period in equal amounts over each year of the asset’s useful life.

Applying the depreciation equally over the asset’s useful life is also called straight-line depreciation.

To see how this works, let’s look at an example from invest-2win.com:

Example: You purchase a warehouse for $900,000. The land where the warehouse resides is valued at $120,000. The building is valued at $780,000. Current law allows you to depreciate commercial properties by equal amounts annually over 39 years. Your depreciation deduction for the first year is based on the mid-month convention. The day of the month that you purchase the property doesn’t matter. You can only deduct half of the first month’s depreciation. If you put the warehouse into service on June 1, you are allowed to deduct 6.5 months of depreciation for the first year.

780,000/39=$20,000 per year
6.5 X (20,000/12)=$10,833 For the first year’s depreciation

Accountants would calculate a full year of depreciation for the above warehouse (commercial properties) as: 780,000 X 2.56%=19,968 as a full year of depreciation.

A full year of depreciation for a residential income property with the same figures would be:
780,000 X 3.64=28,392.

How Can Depreciation Help Me?
As with any expense, depreciation is a deduction that allows you to write down your taxable income for the year. This means that you will have less taxable income and greater potential profit.

Real estate investors can take advantage of depreciation expenses on the buildings as well as land improvements or capital improvements. This means that certain upgrades you make to your property can help you reduce your tax liability. Land improvements include general landscaping and safety upgrades including sprinkler systems, sidewalks, or walking paths. Capital improvements include adding value to the building with items like an addition, making your office green with eco-friendly building materials or adding a roof.

Let’s look at one more example from invest-2win.com to see the depreciation on capital improvements.

Example: You have owned the above warehouse for about 7 years now and it is in need of a new roof. The cost of the new roof is $19,500. You are allowed to depreciate the cost of the roof over 39 years. If you put the new roof on in July, you are allowed to deduct 5 and 1/2 months of depreciation in the first year.

19,500/39=$500 per year
5.5 X (500/12)=$229 For the first year’s depreciation.

Accountants would calculate a full year of depreciation for the roof as:
2.56% X 19,500=$499.

Note that land improvements can be depreciated over a 15 year period using 150 declining balance.

Until next time……rob

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