Daggumit, show me how to lose money faster a young and na’ve Dr. Anderson instructed his accountant. I mean, I just spent $175,000 on an investment property and I can’t write that off this year but rather 27 ” years instead” Fortunately for me, the accountant was patient and understanding.
As many of you know, one of the major benefits of owning real estate is the tax benefit. Specifically, the Government allows you to “pretend” you are losing money on a property when in fact it is really increasing in value. On some of our investments, we were pocketing $1,000′s of dollars per month tax free (well, sort of) and it is all completely legal.
In our preparation for really understanding how the Go Zone can have a major impact on investors, we have to take a step back and understand a little bit about the tax laws related to real estate activities.
Disclaimer: We are not tax attorneys or advisors. The information contained in this article is for educational purposes only. Please consult your appropriate legal/tax advisor.
What Is Depreciation?
Oh, boy now we get to talk about the exciting stuff… taxes, depreciation, “root canals”. As a real estate investor, you DO NOT need to know all the specifics however you DO need to know enough to think through the approximate tax implications of a potential deal. Then, if it looks good to you, you can then double check with your tax advisor.
Depreciation refers to the periodical decline in value of a property due to wear and tear that naturally occurs over time. Since land never wears out, it is not subject to depreciation. Land costs even increase over time. As per the law, a residential property has a depreciation period of 27.5 years and a commercial property has 39 years, both on a straight line basis.
There are multiple methods to compute an asset’s depreciation value. The simplest and most common method used is the straight-line method. The straight line method implies that the depreciation value of a property is equal every year of its useful life. The depreciation value is calculated by dividing the purchase amount of the property by the corresponding depreciation period. So, for example, if you bought property consisting of a house and land with the house costing $200,000, you could “pretend” you lost $200,000/27.5 = $7,272 of value and potentially “write this off” your other income.
Suppose this property actually produced $600 per month positive cash flow and actually APPRECIATED 7% this year. From a simplistic view, we would make $7,200 in income, lose $7,272 in depreciation, and thus have a net loss of $72. Until we sell the property, we can ignore the actual appreciation in value. Suppose the person who owns this property is in the 33% (28% Fed 5% State) tax bracket. Even though they put $7,200 in their pocket, the income tax liability may actually decrease $24; without the depreciation, they would have owed $2,376 in taxes!