How does Depreciation Work?

Question

can someone explain how depreciation works in a nutshell, and how it helps your taxes?

Jon Holdman · Answer

These guys have already explained how you get the deduction.  It can often make the net taxable income for a rental property negative.  You may be able to use that to offset other income, as Rich mentions.  However, there are limitations.

The IRS calls this negative taxable income a "passive loss".  Once upon a time, there were no limits on deduction passive losses from ordinary income.  These were the "tax shelters" of yore.  No more.

Rich mentions the $25K limit.  That's a $25K special allowance.  It allows you to offset up to $25K in ordinary income with passive losses.  But you only get it if your AGI is under $100K.  Married filing jointly or single, doesn't matter.  Over $150K AGI and you can't take any of this special allowance, in between $100K and $150K is phases out.

If you're a "real estate professional", you can take unlimited passive losses.  That's not an easy designation to earn, though.  Its and IRS designation, and has nothing to do with licensing.  To be a real estate professional, you must spend at least 750 hours per year doing real estate activities AND you must spend more time doing that than anything else.  if you have a 40 hour per week job, 2080 hours per year, then you must spend 2081 hours per year doing real estate activities to get this designation.

There's another kicker for depreciation, too.  It reduces your basis.  If you buy a property for $100K, then your basis starts at $100K.  If you take $25K in deprecitaion, and then sell, your basis is reduced to $75K.  If you sell for $150K, then your taxable profit on the sale is not  $50K (sale minus purchase) but $75K (sale minus basis).  Further, you will pay "depreciation recapture" tax on the amount of gain up to the amount of depreciation.  That tax is at your ordinary rate, though its currently capped at 25%.  You pay capital gains tax (short term or long term, depending on how long you held if) on the remaining gain.

If you have passive losses you can not take, these carry forward.  Then, when you sell a property (any property, not necessarily the one that generated the losses), you can take these.

Complicated?  Yep.  Doing real estate without a CPA is a bad idea, IMHO.

Rich Weese · Answer

On real estate you buy and rent out, the govt allows you to take a portion of depreciation each year of an equal amount. This is the price you pay for property, less the land value. The remaining # is then depreciated over 27 and one half years. The govt just came up with the period of time.  You have some limitations, but the depr goes on your sch RI(I think) and if if is $7000, it reduces your income by a like amount. Limited to 25K per person per year UNLESS you're "in the business" of real estate- then there is NO LIMIT.  Think about it. Own 50 homes and take 5K in depr on each, you just covered your first 250K of income with no taxes owed
    This is how I and many others earn nice chunks of income, file an annual tax return and pay NO taxes, and I'm proud of it. This is also why I always argue with posters about having all free and clear real estate. I absolutely refuse to pay income taxes. Hope this gives you an overview. I'm NOT a cpa, just a very astute investor. Rich.

Scott R. · Answer

Depreciation.... Yea, in real estate they go it down good. Nice article.

There is depreciation on chattle.

and, well i guess sometimes theres another when you dont mow your lawn and your wife depreciates you... its like the opposite of appreciate.....

Niman S. · Answer

I wrote a fat article about depreciation, nice little story. You can see it here on BP http://www.biggerpockets.com/articles/625

Ryan Webber · Answer

Depreciation and being able to retain the asset are the biggest advantages of carrying the note for someone versus renting.

The advantages of carrying the note are that the maintenance/management is extremely minimal and you get the down payment on the front end.  The properties that I carry notes on have significantly lower collection issues and they are much more likely to stay longer in the property, which means lower remodeling costs.  You don't get maintenance calls from a note, either, and I really like that.

Yes, you can leverage and/or refinance a note receivable without selling the actual note.  It is a little trickier than refinancing a rental, but it absolutely can be done.

No, you normally don't have to take a 20-40% discount to sell the note, either.  10-25% is what I say is normal but it depends on the note.  I know a local investor that will buy them for a 5% discount with no seasoning.  You can also normally get more on sales price with seller financing than on the normal retail market.

Depending on your state's laws a foreclosure is probably a bigger hassle than an eviction, but for my state the paperwork is similar in intensity and it takes me about 45 days to foreclose rather than 18 to evict.  Bankruptcies can affect that time line.

Moratoriums on foreclosures as Mike referenced were lender specific (Fannie and Freddie, BOA, etc.) and voluntary and did not affect individual note holders in any way.

There is some pending federal legislation right now that could affect seller financing and then there is always state legislation that you need to be aware of.

I have to disagree with Rich's advice that you should NEVER sell.  IMHO, every single homeowner in the bubble markets SHOULD have SOLD their property 2 years ago NOT using owner financing and moved to the Midwest.  There are always reasons to sell and, yes, there can be tax consequences for selling (except for a 1031), but sometimes its the best thing to do for your circumstances.

In my opinion, carrying notes is a very stable way to profit from your assets but it does have some strong disadvantages also.  I keep a mixed portfolio so I get the benefits of both.  I have the stability of notes and I still get the depreciation on my rentals.

Robert Jenkins · Answer

You can depreciatiate (write off) the value of the improvements on your investment property. On residential i believe it's 28 years.

Say you buy an investment home for 500k and the assessor has the land valued at 200k you can then write off 300k (improvements) divided equally over 28 years or 10,714k a year you can write off on your taxes. Now say you've collected only 15k in rents now the government will get their hands on a portion of the 5k difference instead of 15k.

Basically it helps lower your taxable basis.

For commercial it's 39years and for those people who are really just "hiding" money what they do is buy properties in a leasehold interest (which is pure improvements) and they get to write off everything over 39 years.

How does Depreciation Work?

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