Depreciation is the loss of value in an asset due to certain conditions like wear and tear. For real estate, physical improvements like buildings and other structures experience depreciation. It may not sound like a good thing, but for real estate investors, it is advantageous. Depreciation is a non-cash expense that can be used to reduce taxable income, and the tax benefits can be offset by other expenses, such as repairs and maintenance.
The three most common types of depreciation in real estate are physical, functional, and economical.
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Different types of depreciation
There are three types of depreciation in real estate: physical, functional, and economical.
Physical Depreciation
Physical depreciation is the wear and tear of a property due to age, weather, and other factors. For example, a carpet that is starting to show its age or paint that is beginning to fade would be considered physically depreciated.
In the context of real estate investing, physical depreciation can have a significant impact on an asset’s value. This is because potential buyers will often be willing to pay less for a property that needs cosmetic repairs or updates. Investors need to factor physical depreciation into their investment decision-making process.
Functional Depreciation
Functional depreciation is when a property becomes outdated and no longer meets the market’s needs. It is caused by obsolescence or the property no longer being able to function as it was originally intended.
An excellent example of this would be a home built before the advent of central air conditioning. While this type of home would have been considered cutting-edge when it was first built, it would now be seen as functionally depreciated in today’s market.
Just like with physical depreciation, functional obsolescence can have a major impact on an asset’s value. This is because outdated properties are often perceived as being less valuable than those that have been recently updated. As such, investors need to consider functional obsolescence when estimating an investment property’s future value.
Economic Depreciation
Economic depreciation is when changes in the market make a property worth less than it was previously. It occurs when an asset loses value due to changes in market conditions.
For example, a property in an up-and-coming neighborhood may experience economic appreciation as new businesses move in and drive up demand for local amenities. Conversely, a property in an area experiencing economic decline may suffer from economic depreciation as companies move out and crime rates increase.
Economic depreciation can be difficult to predict, which is why it’s so crucial for investors to do their homework before making any investment decisions. By understanding the forces at play in the local real estate market, investors can gain valuable insights into whether or not an investment property is likely to experience economic appreciation or depreciation in the future.
The Importance of Due Diligence When Evaluating a Property for Depreciation Risks
It is crucial to do one’s homework before making a real estate investment in order to avoid future disappointment. Depreciation risks, which can cause a decrease in property worth over time, are an important factor to consider. Investors should start their due diligence by checking the property’s upkeep records for evidence of costly fixes or upgrades. Understanding the property’s systems and components’ ages and conditions can help you plan for physical decline and functional failure.
The next step for buyers is to look at the local real estate market and economic circumstances to see if there will be any shifts that could affect the property’s worth. A drop in demand for the property could occur, for instance, if new construction or building projects were to be built in the vicinity. Future zoning or regulation changes that may have an impact on the property’s worth should also be carefully considered.
Investors should collaborate with seasoned professionals, such as real estate agents, appraisers, and contractors, to accurately assess the property’s condition and value. By undertaking exhaustive due diligence, investors can identify potential depreciation risks and make informed investment decisions, ultimately maximizing their returns and minimizing their risk exposure.
How Depreciation is Used in Real Estate
Depreciation can be a significant expense for landlords and property investors. Losing a property’s value over time significantly impacts its viability. Property owners must constantly upgrade their rental properties to remain relevant and valuable.
The IRS allows depreciation to be deducted from the gross income and used as tax savings. Different depreciation methods can be used to reduce property tax. The most common is the straight-line method, which takes the ratio of the asset’s valuable years to the difference between the asset’s recovered value and purchased price. The resulting amount is deducted annually over the useful life of the property, resulting in smaller tax deductions over a long period.
Another standard method is the accelerated depreciation strategy. A lump sum that can be up to 100% of the asset value is deducted in the first year (or within the first few years), offsetting the actual cost of the asset. This method can even result in the investors having extra cash in their pockets.
Depreciation may sound like a complex topic, but it’s a reality in real estate that has its own benefits. If you want to experience the advantages of real estate investing but are held back by a lack of expertise and experience, then consider investing in real estate funds.
Real estate funds are pooled investments managed by a professional real estate fund manager who handles the property investment details like scouting, purchasing, remodeling, renting, repairs, and monthly expenses. You no longer have to worry about the depreciation costs of your properties since they will take care of it. You only wait for the monthly rental income and watch your investment capital appreciate. To learn more about this opportunity, get in touch with Saint Investment for a free consultation.
Frequently Asked Questions:
Physical depreciation is generally calculated based on the age, condition and use of the land, rental property, business, service or information. An appraiser or real estate professional can help you determine the extent of physical depreciation on a property and its potential impact on the value and use of the property.
Determining functional obsolescence can be more subjective than calculating physical depreciation and can be based on different ways and rules. It often involves assessing the property’s usefulness and market appeal relative to other properties in the area, taking into consideration factors such as location, age, design, and amenities. Appraisers and real estate professionals may use different basis for evaluating functional obsolescence, such as comparing the property to similar ones that have recently sold or assessing its compliance with current building codes and zoning regulations. While there is no set of hard and fast rules for determining functional obsolescence, it is important to consider this factor when assessing a property’s market value and potential for rental income or resale.
Depreciation can have a significant impact on a property’s value, assets, and its ability to generate income over time. Examples of physical depreciation include wear and tear on the building, aging of the property’s systems, and damage caused by natural disasters. Functional obsolescence can occur when a property no longer meets current market standards or requirements, such as outdated layouts or inadequate amenities. As a result, properties with high levels of physical depreciation or functional obsolescence may have a lower number of interested buyers or tenants, lower rental rates or sales prices, and longer marketing times. A professional appraisal can provide accurate results on the extent of depreciation and help you make informed decisions about how to address it.
Yes, depreciation can have tax implications for real estate investors. Investors can claim depreciation as a tax deduction to offset rental income, but they may also be subject to recapture taxes if they sell a property for more than its depreciated value. Investors should consult with tax professionals to understand the tax implications of depreciation in real estate.
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President of Saint Investment Group
Nic is a two decade seasoned expert in investing and capital raising, specializing in Real Estate and debt markets. With Saint Investment Group, he leads large-scale distressed asset purchases and innovative syndications for investors.
