@Anjali A.
Hi Anjali.
Depreciation is a Business deduction meant to allow you to lower your tax bill so you can save to replace the building (legally called the Improvements) on the land. Note, Land is not depreciable, only the improvements are.
The concept works like this.
Let's say you own a Limo business. You pay $50k for the Limo and put it to work.
You are not allowed to take the $50k as an expense.
Instead, the IRS says that you can smooth out the $50k expense into a life expectancy when your Limo needs to be replaced. Let's say that's 5 years that is allowed by the IRS.
So, we divide the $50k Limo expense by 5 years and get $10k per year.
Instead of taking the $50k expense in Year 1 on your tax return, you take $10k as a depreciation expense in year 1, year 2, etc. all the way to year 5.
We can probably get a better answer from a CPA, but I believe the reason why this is the case is to smooth out the Income.
In other words, if you took the $50k expense in the year you bought the Limo, your income looks really negative or very low! But in year 2, it pops up by at least the $50k that you didn't need to buy a new Limo!
BUT, if you depreciated it for $10k per year for 5 years, the Income is not as crazy and it smooths itself out.
A buyer of the Limo business can basically look at the taxable income and get a clearer idea of your true income versus taking the expense of $50k all at once.
Remember what I said earlier that the $10k per year depreciation is given to you because you were disallowed to make the full $50k expense on the Limo.
However, it's also true that the Limo will need to be replaced. So one aspect of this is that every year, your Limo is worth $10k less in reality as well as for tax purposes. So by Year 2, it makes sense your Limo is worth only $40k.
By year 5, it's worth ZERO. So yes, this expense makes a lot of sense.
NOW.... Real Estate is a totally different animal.
While we are allowed to expense the building the same way, the value of the building actually goes UP!!
So, we are allowed to make a depreciation deduction for a residential building annually for 27.5 years!
We call that a phantom deduction and it's a huge advantage to save on paying taxes until you sell.
When you sell Real Estate, you must then recapture the depreciation by paying a tax of around 25% on all the accumulated depreciation. We call that recaptured depreciation.
There is a way to NOT pay the recaptured Depreciation AND also to defer your Capital Gains taxes.
OK!!!! I know.... I've beaten it to death and gave you a hell of a lot more info than you need! Sorry about that!
It's called a 1031 Exchange and I'm sure you can find a lot of BP members that have a lot of knowledge and can service your Exchange to a higher cash flowing property.
If you do a search for "1031 Exchange" here in Bigger pockets, you'll find plenty of postings.
As far as advice on what to buy, it's up to you to figure out your strategy.
What I do think is that everyone should be knowledgeable at least 4 ways of making money in Real Estate: Cash Flow, Appreciation, Mortgage Reduction and Tax Savings.
I also believe everyone should have a fundamental understanding of Economics so they can make a 10 year pro-forma business plan on their target property.
I know this doesn't help as much as giving you a direct opinion, but that's really up to you.
Which ever way you choose, just know that buying a property that moved up from $240k to $450k with a 20% down payment AND making good cash flow for 6 years ago is fantastic! Keep up the good work!
