The concept of depreciation
When purchasing rental property to be held for the long-term, it’s important to understand the concept of depreciation as a valuable advantage come tax time each year.
Simply put, the IRS treats rental property as an asset that loses part of it’s value every year. How much is being lost? The IRS says that the building on the property (not the land it sits on) must be depreciated over a life span of 27.5 years. Why exactly 27.5 years? I have no idea. But hey – it’s the IRS…they’re allowed to be arbitrary.
So using what’s known in accounting circles as the straight-line method, you would be able to deduct 1/27.5 of the value of the building each year as a loss. This depreciation cost is further defined as the purchase price of the property plus your transaction costs, less the value of the land.
Obviously, depreciation is strictly a paper loss. Most assets will deteriorate over time, and in the case of real estate, a building will certainly fall down at some point in the future ( even if something was done to it to keep it standing for a longer period of time).
Of course, land does not deteriorate. So it is never included in the depreciation expense. So you and your accountant will decide on a “reasonable” amount to be attributed to the land value component of the total property value. (It would be bad if the IRS didn’t agree with this amount.)
Depreciation as a big contributor to loss
Most rental properties take some time after you purchase them to throw off positive cash flows. You’ll need time to make improvements that will attract better tenants that will enable you to charge higher rent, all adding to a positive net income. But depreciation, being strictly a paper loss, will help in adding a great deal of expense to your overall expenses on a property each year. And this may help show your property as having a negative cash flow. The loss on the property can then be used to offset your personal income, if your income is less than $150,000 a year. Consult your tax advisor on new tax treatments to this rule.
The great equalizer
Once you’ve determined it’s time to sell your rental property, however, it will be time to “settle up” with the IRS for all the prior years of depreciation that you took. Here is when you will have to subtract from the cost basis for the property, all the depreciation expenses you’ve taken since you owned the building.
As an example, say you purchased a property for $500,000, made improvements of $100,00, and took roughly $20,000 in depreciation each year for 10 years. Your new adjusted basis would be $400,000.
Original basis cost $ 500,000
Adjusted basis 600,000
Depreciation ($20,000/year for 10 years) 200,000
New adjusted basis 400,000
If you now sell the property for $800,000, your new, lower adjusted basis due to depreciation will throw off a profit of $400,000. And, you’ll owe capital gains on this profit. (Of course, with the capital gains rate currently at 20% , it’s usually lower than your individual tax rate.)
So while the IRS giveth (in the form of the depreciation tax advantage you had while owning your rental property), it also taketh away (when it comes time to sell, and your cost basis gets reduced by the depreciation expense you received while holding the asset).
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