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Understanding Depreciation in Real Estate

When it comes to real estate investing, many terms and concepts can be confusing for a new real estate investor. One of those concepts is depreciation deduction. Most real estate investors know that it's a vital tax concept but put off understanding what it means. 

In reality, depreciation in real estate is a fairly simple concept, and understanding its definition can help you make the most out of your investments. 

This post discusses the definition of depreciation in real estate, how it works and why real estate investors need to understand it. However, consulting with a local tax adviser is still advisable since local tax regulations affect your real estate investments. 

What is Depreciation, and How is it Related to Real Estate?

Depreciation is an accounting method used to allocate the cost of a long-term asset over its useful life. 

It's an expense reported on the income statement as a revenue reduction. In the United States, the federal government allows taxpayers to deduct a portion of the cost of their real estate investments through the depreciation tax deduction. 

Depreciation tax deductions can be claimed on any commercial and residential rental property and can be used to offset other income taxes. 

Depreciation allows investors to write off the wear and tear that their rental properties experience over time. For example, if you purchase a rental property for $100,000 and it depreciates by 10% over ten years, you can write off $10,000 of the purchase price in your taxes each year. 

How Does Depreciation Affect Real Estate?

There are a few things to remember when depreciating real estate. 

First, only the "depreciable value" of a property can be written off—this generally excludes the value of the land on which the property is built. Land is not depreciable because dirt and rocks don't deteriorate. The capital improvements built on the land, though, are part of the depreciation expense. Your accountant can devise a way to maximize the property's depreciation by segregating the cost of the land and the building value.

Second, different types of properties depreciate at different rates. Commercial real estate takes 39 years to decline, while residential properties take 27.5 years. Personal residences can't be depreciated. Only properties bought as an investment or used as a business are subject to depreciation.  

Lastly, you can accelerate depreciation by introducing leasehold improvements. If you offer the property to a tenant, you can make nonstructural improvements that can be depreciated within 15 years. 

How is Depreciation Calculated?

Investors should also be aware that there are two depreciation methods: straight-line and accelerated. The straight-line depreciation method spreads the deduction evenly over the asset's useful life. The accelerated method allows investors to deduct more in the early years and less in the later years. 

To use the straight-line method, subtract the property's salvage value from the asset purchase price and divide it by useful life. The result is the annual depreciation. To deduct more depreciation in the early years, your accountant can work on a cost segregation method that lets you depreciate several components of the property upfront. This results in more savings in the beginning but less depreciation to claim in the future. 

If you decide to sell the real estate property for more than its cost, less the depreciation claimed, the IRS can see the excess value and charge a depreciation recapture tax. This is 25% of the depreciation value, which the IRS considers as ordinary income. 

Conclusion 

Property depreciation is an important tax concept that real estate investors must be aware of. By understanding how depreciation works and how it can be used to your advantage, you can save money on your taxes and reinvest it into growing your business. 

Real estate syndication allows you to invest in real estate without worrying about depreciation costs and taxes. Together with other investors, you pool together your capital and work with a syndicator to handle the entire transaction - from purchasing, repairs, remodeling, and renting. A professional fund manager oversees the operations and management of your properties, lowering risk and allowing you to enjoy consistent cash flow from the passive rental income of your properties. Check out Saint Investment's Real Estate Funds to learn how you diversify your portfolio and enjoy guaranteed passive returns from your real estate investments.

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