Types of Depreciation in Real Estate

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.

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Functional depreciation is when a property becomes outdated and no longer meets the market's needs.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 This is because outdated properties are often perceived as being less valuable than those that have been recently updated.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.                 

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.

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