Simple depreciation explaination

3 Replies

This was taken from a PM to a colleague.... After writing it up, I figured I'd put it here for your entertainment;)

About the tax comment in my post...

This is a simple example. The numbers are to show the point. Don't get caught up in the small details.

Buy a house to rent out. $100K purchase. The IRS allows you to deduct a non-cash expense for depreciation, because houses (like all capital equipment) wear out. You depreciate the improvement (the house) not the land. For that $100K, say your house is $82.5K and land is $17.5K based on your property card from the county appraiser's office. You rent the house monthly for $1,200 and have $500 actual expenses. So you "make" $700 per month... but you have a mortgage, and interest averages $450 monthly. So your net is (roughly) $250 per month or $3,000! Do you pay tax on that $3,000? Not today. Here's why.

As I said earlier, capital equipment that is used to make money for a business wears out. Cars, trucks, chain saws, ... houses. The IRS allows you to account for, via a deduction in the current tax year, the "wearing out" of your equipment. Now here's the key. The algorithm the IRS uses allows for houses to "wear out" in 27.5 years. So, numbers wise, your $82.5K equipment (house) wears out $3,000 every year. ($82,500/27.5) And that $3,000 is expensed, meaning it's as if you wrote a check to someone for a property service... except you don't write a check. It's a non-cash, bookkeeping expense.

So the annual after depreciation income is $0. You have $3,000 more in your checking account, but no tax liability(*). There are other ways to manage tax liability beyond the first year. You can research Estate Planning methods and stuff like the 1031 exchange process on BiggerPockets or with your financial planner.

(*) No current tax liability. The IRS may recapture later unless you take other action.

I'm glad I found this post, since I have a similar question about depreciation. In my case, the allowable depreciation is greater than the net income (after PITI and other expenses). I have used Turbo Tax for many years, but just want to make sure that it is doing what it should, and that I fully understand the implications of the depreciation allowance.

Take your example above, but after all expenses, the net income is $150/month, instead of $250/month.  Your depreciation can reduce your taxable income completely, and still have $100/month of unused depreciation left over.  In other words, $1200/year gets rolled over to the following tax year.  Line 21 on the Schedule E is a negative number.  I see that same number on Form 8582 line 1b, and the prior year's unused depreciation on line 1c.

Two questions:

1. When the net income for a given tax year does start to exceed the allowable depreciation in that tax year, then can one draw on the "banked" depreciation that was not used from prior years?

2. At the time of the sale of the property, the IRS expects the gain to be calculated with an adjusted basis that considers depreciation, whether in fact you used the depreciation or not, right?  So if you still have unused depreciation at the of the sale, does that unused depreciation increase your tax basis for the gain calculation?

I hope this makes sense.  I'm still a newbie at all of this, so please forgive me if I'm obviously off base here.

@Steve Scherrer

1. Yes. Suppose in year one your depreciation/amortization exceeds net income by $1,000. On Form 8582 Worksheet 1, you would enter in column B the net loss of $1,000. Suppose in the second year your net income exceeds depreciation by $1,000. On Form 8582 Worksheet 1, you would enter in column A the net income of $1,000 and your previous year $1,000 loss would show up in column C "Prior Year Unallowed Loss" which would net you $0. 

2. Yes, the IRS will adjust your basis regardless of whether or not you are claiming depreciation. Can you expand on your second question?

@Brandon Hall , thank you so much for your response and taking the time to help out a newbie like me.

It's my understanding that when selling a rental property, that the IRS would expect the gain calculation to include depreciation in the adjusted basis that is "allowed or allowable" (a phrase I've read here and here).  It sounds to me that your basis would be reduced for the "allowable" depreciation, even if you don't claim the depreciation deduction.  Perhaps I'm just confused in my reading of this?

Say you buy a rental property for $100k ($85k building, $15k land), and never claim any depreciation or add any capital improvements that would increase your basis either.  You sell the property ten years later for $110k.  Is your gain $10k?  Or would the IRS claim that since you were allowed to depreciate the original $85k over the last ten years (say that amount is $11k)  and so your taxable gain would be $10k + $11k = $21k?

In other words, is your Gain = Basis - DepreciationUsed, or is Gain = Basis - DepreciationAllowed (whether used or not).  I'm guessing that I'm just reading this wrong, but I'm a newbie so I have to ask a question like this.  :)

This kind of relates to my first question too, where there is unused "banked" depreciation (Form 8582 1c is still negative).  Would that unused depreciation reduce the amount of depreciation that was recaptured when the property is sold?