It isn't fun to consider how your real estate properties have deteriorated as they face another year of use by tenants, harsh weather conditions, aging building materials, and other factors. However, when that deterioration results in tax deductions and increased cash flow, then maybe it isn't so bad. When it comes to accounting books and tax returns, this deterioration is known as depreciation.
What is depreciation?
The IRS defines depreciation as an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property.
For real estate, depreciation is the calculation of loss of value on any improvements to a property. In most cases, land, as the basis of a property's value, will not endure loss in value through wear and tear. Therefore, the value of the land doesn't usually factor into a depreciation calculation. The buildings that are constructed on the land become the improvements eligible for depreciation deductions.
At a basic level, depreciation accounts for the portion of the property that decreases in value simply by using it, the portion of the property that can wear out and require replacing. Because nothing lasts forever, each use of a building is one use closer to making that building useless. There is a cost to fix a property in order to preserve that property's usefulness for as long as possible. This cost reduces the value of the property and becomes an eligible tax deduction calculated as depreciation.
How does depreciation increase my cash flow?
When a property is depreciated on a tax return and deductions are taken from the income earned on that property, you pay less tax to the IRS. A property may have a $12,000 annual pre-tax net cash flow but then will owe the IRS income taxes on that $12,000. By utilizing depreciation the taxable income amount owed to the IRS will be reduced. This allows a greater portion of that $12,000 to remain in the investor's pocket, resulting in an increased after-tax net cash flow.
Why is depreciation costing me so much?
Like capital gains taxes that incur as a result of a sales price being greater than the cost basis of a property, depreciation deductions will be recaptured by the IRS when the sales price exceeds the adjusted cost basis of a property. If an investor depreciated a property by $50,000 over the time of ownership and reduced a property's cost basis from $300,000 to $250,000 and then sells the property for $290,000, the investor will owe a significant percentage in depreciation recapture of that $40,000 difference. However, also like capital gains taxes, depreciation recapture can be deferred through a 1031 Exchange.
Depreciation isn't a straightforward tax strategy. In our next blog we'll look into a few other factors of depreciation.