What is depreciation?
Depreciation is a tax benefit that you get from owning rental property. I look at it as an incentive set up by the government to encourage real estate investors to buy property and rent it out.
When you buy rental property, I think of the government telling you that the property itself will “wear out” over time and that they are reducing your income by the amount that they think the property is wearing out over time. This then reduces the amount of income tax you are paying so that you have money that you can use that to maintain or replace the property as it wears out.
Over what period of time can I depreciate a property?
For residential rental buildings you can depreciate them over 27.5 years. Nomads may buy retail and commercial structures outside of the Nomad investment model. However, if they did, typically retail and other commercial structures would be depreciated over 40 years.
When do I actually get depreciation?
You can typically structure your taxes to get depreciation in one of two ways.
First, you could wait until you file your taxes at the end of the year and get your depreciation benefit as a reduced income tax. This might be in the form of a smaller tax bill due or if you've been paying all your taxes throughout the year, a tax refund.
Receiving the reduced income taxes from depreciation as single lump sum at the end of the year might be especially helpful for Nomads that have a hard time saving money and might need the extra money for down payments on future Nomad properties. In this way, one could almost think of the existing Nomad properties you are renting is further providing the down payments to buy additional Nomad homes.
The second way you can structure your taxes to get your depreciation benefit is to adjust the exemptions from withholding on your W4 form. By doing this, less taxes will be taken out of your paychecks each pay period. The thought is that you're going to have lower taxes due at the end of the year from your depreciation so you might as well reduce the amount of tax you're paying with each pay check instead of getting a refund check back at the end of the year.
By adjusting your exemptions on you W4, you are really seeing your depreciation benefit as increased “cash flow” through the year in each of your pay checks.
Is depreciation a scam?
No. Depreciation is a benefit of owning income producing real estate that you receive as a reduction in your taxes and is approved by the IRS. You can read more about it on the IRS website in Publication 527 which is all about depreciation.
About how much will depreciation be?
Depreciation for Nomads is based on the purchase price of the property you buy, the value of the land and your effective tax rate. So, it is really hard to tell you exactly what your depreciation benefit will be.
In the Nomad Calculator Classic, we allow you to enter in the value of the property you're buying and your effective tax rate so that we can do an estimated calculation of what the depreciation benefit will be for you on each Nomad property you buy.
Here's a simplified example of how the depreciation calculation would work. Of course, when filing taxes use the IRS provided forms for calculating depreciation.
You purchased a Nomad property for $200,000. After living in the property for a year, you rent it to a tenant and can start collecting depreciation on it in that second year.
Let's assume that the value of the land on the property is worth $40,000. You can depreciate the value of the property (not including the land), so you can depreciate $200,000 – $40,000 = $160,000.
Since this is residential rental property you can depreciate it over 27.5 years. So, each of the first 27 years you can depreciate $160,000/27.5 = $5,818.18 per year and in the 28th year you can depreciate half of that amount or $5,818.18/2 = $2,909.09.
To over-simplify, the $5,818.18 depreciation benefit is subtracted from your income. So if you earned $100,000 that year, you'd reduce that income by $5,818.18 and pay taxes on $100,000 – $5,818.18 = $94,181.82.
So, if you were paying tax at a 25% effective tax rate, you really saved $5,818.18 * 25% = $1,454.55 in taxes from depreciation.
As you can probably see, the purchase price, the land value and your effective tax rate impact how much depreciation will be.
Why can't you just tell me how much depreciation will be?
Since the depreciation is based on the value of the property, how much of the value of the property is the value of the land and your effective tax rate, it is hard for us to give you an exact value for depreciation.
Plus, there are situations where your specific tax situation may limit how much depreciation you can take. For example, as your modified Adjusted Gross Income rises above $100,000 tax rules change. However, Nomads may be able to qualify as real estate professionals which grant you more favorable tax status. Talk to a CPA that specializes in rental properties and find out what you need to do to qualify if you think this may apply to you.
Is depreciation different than cash flow?
Yes, depreciation is a benefit you get (on your taxes) from owning income producing real estate. Cash flow is money you make from the income on your property after all your expenses. It is true that sometimes we look at depreciation as if it was cash flow–especially if we decide to increase the exemptions and collect the depreciation from our property as an increase in pay on each of our pay checks. This is more of a way of looking at it than being technically correct way of describing depreciation though.
Is depreciation different than appreciation?
Yes. Depreciation is a tax benefit you get from owning income producing real estate. Appreciation is the tendency for property values to go up over time.
Is depreciation based on my tax rate?
Yes. The amount of depreciation you get from the property is usually based on the purchase price of the property minus the cost of the land. The amount of “spendable” benefit you get from this depreciation though is based on your effective tax rate since the depreciation amount is used to reduce the amount of income you're paying tax on.
As an over-simplified example, if you had a property that generated $10,000 per year in depreciation benefit, you would reduce your income by $10,000 and pay taxes on the reduced income amount. So, if you earned $80,000 per year, you would reduce your income by the $10,000 depreciation to $70,000 and pay taxes on the $70,000. That means you that paid $10,000 times your effective tax rate less in taxes.
What is effective tax rate?
Effective tax rate is the percentage of your taxes that you're paying based on your taxable income.
Our taxes are calculated in buckets. You pay a certain amount of taxes on the first $X you make and then another tax rate on the next $Y you earn and then yet another tax rate on the next $Z you earn. This makes it a little more challenging to calculate how much tax you might need to pay quickly and easily unless we use something like the effective tax rate.
The effective tax rate allows us to take the different tax bracket tax rates into account but give us a single number to estimate how much tax we are paying overall.
An example of how to calculate the effective tax rate would be to take the taxable income of $80,000 and divide the $20,000 in taxes we paid by the taxable income $80,000 giving us a 25% effective tax account. You can often find your effective tax rate on your tax return.
Is depreciation guaranteed?
That's an interesting question for me to answer. In one sense, I want to be able to say yes. Unless the government changes our tax code, depreciation is as close to a guaranteed return as you can get. If you own an income producing property as a Nomad you get the depreciation benefit.
However, if the government changes are tax laws and eliminates depreciation, it changes everything.
Depreciation is not dependent on rents, appreciation, cash flow, appreciation or anything else like that though. It really is a tax benefit of owning income producing property.
Where can I get more information on depreciation?
There are two places I'd recommend you go to get more information on depreciation.
First, you can read about it straight from the IRS on their website in Publication 527.
Secondly, you can go to your CPA and get information on depreciation and how it might apply to your specific tax situation. And, I'd strongly recommend that you do that.
Should I talk to a CPA before I start Nomad?
Yes, Nomads are smart and build great teams around them to support them achieving their financial goals. That means talking to and getting good advice from knowledgeable professionals like CPAs.
A good CPA can look at your tax situation and your plan to do Nomad and make suggestions that will end up saving you money and headaches.
Why do you use two different numbers for depreciation?
When we model Nomad with the Real Estate Financial Planner™ software we often show two different charts for depreciation.
The first chart, shown below, is the gross depreciation benefit. It takes the purchase price of the property and subtracts out a percent of that value to exclude the value of the land. This is the estimated amount that you'd subtract from your income on your taxes.
The second chart, shown below, is what we call the cash flow from depreciation. Depreciation isn't really cash flow, but if you think of the amount that you actually save on your taxes as money you get to put in your pocket you might be able to see why we call it cash flow from depreciation.
We calculate this by taking the effective tax rate you entered in your assumptions for the calculator and multiplying that by the gross depreciation benefit. This tells us how much taxes you saved from this depreciation. You can get this amount monthly by adjusting your exemptions on your W4 or at the end of the year as a reduction in how much taxes you need to pay or as a refund from the IRS depending on how you structured your tax payments.
Does the loan I get affect depreciation?
No. The type of financing you have on a property does not usually affect the depreciation benefit you get. There is a very rare exception when you acquire a property by taking over a loan at the time of purchase, but that has more to do with how you'd determine the value of the property for depreciation than it does the actual amount you can depreciate.
Does the interest rate on my loan affect depreciation?
No. The interest rate on your loan has no impact on your depreciation benefit.
Does the cash flow on my property affect depreciation?
No. Cash flow is unrelated to depreciation even though sometimes we refer to the benefit you get from depreciation as cash flow from depreciation. Cash flow from depreciation and cash flow are two totally separate things.
Does the appreciation rate affect depreciation?
After you purchase the property, the appreciation rate has no impact on depreciation.
Does depreciation change as the property value goes up?
No. Your depreciation is based on the price you purchased the property for and is fixed.
Why don't you depreciate the property in the first year?
With Nomad you move into the property and live in it for the first year. Since you're living in the property, it is not incoming producing property yet and you only depreciate income producing property. In the second year, when you move out and rent it out, it becomes income producing property and we begin depreciating it.
If you had a roommate in the first year, you would be able to start depreciating the percentage of the property that was income producing. Talk to your CPA about how to correctly do this calculation.
Do I need to pay back depreciation?
Sort of but not really. The amount you depreciate each year effectively lowers the price the IRS considers you paid for the property. They call this basis. Since you'll pay taxes on the difference between what you paid for the property and the price you sell it for (your gain), you do end up paying taxes on a larger amount.
How does depreciation work when I sell the property?
As you take depreciation each year, you are lowering your basis in the property. When you sell a property you pay taxes on the difference between your basis and your next sale price.
Since depreciation lowers your basis, it means you have more gain and therefore there are more taxes due.
How does depreciation work if I'm doing a lease option exit?
This is the same as if you sold it outright. You pay taxes on the difference between your basis in the property and the net sale price. Since depreciation reduces your basis in the property, you have a little more gain on the property and you'll pay a little more in taxes.
You could decide to do a 1031 tax deferred exchange to delay paying taxes on your gain until a later date.
Can I depreciate the property in the first year if I rent out rooms and have roommates?
Yes. If you are producing income on your property in the first year as a Nomad, you can depreciate a percentage of the property that is producing income.
Is depreciation more cash flow?
In one sense, yes. Depreciation will lower your taxes by reducing the amount of income you need to pay taxes on. The tax savings can be looked at as additional cash in your pocket. I often refer to it as cash flow from depreciation especially when people decide to increase their exemptions on their W4 and get this tax benefit in each pay check.
Do I get depreciation when a property is vacant?
Yes. You get to continue to depreciate your property even if it is vacant as long as it is still in service.
Can I depreciate a property if I have a roommate?
Yes. You can depreciate the percentage your property that is being rented to a roommate.
Can I accelerate depreciation?
There are some strategies where you can decide to depreciate different components of the property at accelerated rates. This is an advanced strategy that you should consult with a professional to discuss if you think you'd like to do it. The overwhelming majority of Nomads will opt not do this.
What rental property can be depreciated?
According to the IRS website, you can depreciate property if it meets the following conditions: you own the property, you use the property in your business or income-producing activity (such as a rental property), the property has a determinable useful life and the property is expected to last more than a year.