The 9 Benefits of Investing in Real Estate: 4. Depreciation

Is depreciation a benefit of investing in real estate? Does that mean the value goes down? I didn’t get it when I first began investing in real estate to the extent that I do now. I did not completely understand the depreciation of an asset, for tax purposes, on an asset that was supposed to go up in value. Depreciation is a wonderful tax incentive to offset positive cash flows against negative losses on paper for tax purposes. This means that I can make $96,000 in positive cash flow and write off $96,000 in deprecation of an asset on paper for tax purposes to offset the income and pay ZERO tax! That is the same as making $192,000 a year at a w-2 job without any tax advantages and paying 40-50% in state, local, and federal taxes. For tax purposes, there are 3 buckets of income: 1) Active (like from a W-2 job), 2) Passive (like from real estate), 3) Portfolio (like stocks, bonds, etc.). Passive losses (depreciation) can offset “passive” income. Generally speaking, passive losses (like depreciation) cannot offset active income. We will touch on some situations where that is possible later, but for now let’s understand depreciation.

I want to help you understand that small portion of the tax code and the basic accounting required by the IRS that can lower your taxable income through depreciation. Buildings, cabinets, flooring, and things like land improvements do not last forever and have an actuarial life expectancy. In other words, they will need to be replaced and different items have different depreciation or useful life expectancies. Therefore, the tax code allows for you to depreciate sticks, bricks, cabinets and other improvements on paper due to their useful life expectancy, but not dirt.

The tax code was never explained to me to the degree that I understood it enough to truly play by the rules. I hope to give you some insights with that regard. As if all the benefits mentioned above from a property that was purchased and financed correctly were not enough, the US government incentivizes this mind blowing, wealth building behavior by incentivizing the behavior through the tax code. Yes, the government wants you to provide housing and will give you the benefit of actuarial depreciation of the asset to offset the income that you realize from your risk. I am not saying that the value of the asset deprecates, and that can and does happen – which is why your buy for cash flow and let time correct any visual value errors. I am saying that the IRS allows you to deprecate the sticks and bricks of your mini business for tax purposes.

If we stick with the same simple example of a $100,000 single family home and we estimate that the dirt is 20% of the value which is non-depreciable, then you would take $80,000 and divide by 27.5 years for residential property and 39 years for commercial property to come up with a “straight line” schedule for depreciation on your taxes. We will discuss bonus or accelerated depreciation and cost segregation later in this book, but I do want you to understand that the IRS expects you to write off or depreciate the sticks and bricks for tax purposes. In this example, your CPA would take $80,000/27.5 years of deprecation or useful life and the IRS would expect you to write down a negative $2,909 of depreciation against the $1,800 of income from the example above. (refer back to my Excel illustrations in the appreciation chapter). This means that if you consider this factor alone, then you would have the benefit of $2,400 cash on cash in year one with a negative write-off of $2,909 for tax purposes, leaving you with a paper LOSS on your taxes of negative ($509) for this property and no taxes would be due! Yes, that means tax-free, or even a loss for tax purposes, even though your rental property created a positive cash flow.

Allow me to expand your mind here by stating the power of this in another way… you can go to work for a big corporation and receive a W-2 wage of say $192,000 a year where you pay around 40-50% in taxes after federal, state, and local gets done with you and end up with $96,000 at the end of the year that you get to keep OR you could earn $96,000 in passive income from real estate, have $96,000 of passive losses from depreciation and pay $0 tax or even show a tax loss. The result is the same pay-in-pocket but with different bosses. Ok, maybe both bosses are toilets, but let’s hope not. I hope you see that for tax purposes, depreciation is yet another wealth-building advantage of real estate.