Are you looking to make the most of your rental property investments? Rental property depreciation is an important tax benefit. It can help you maximize your returns and improve your overall cash flow. In this blog post, we'll discuss the basics of rental property depreciation, including how to calculate depreciation, rental property tax deductions, and more. With this information, you'll be on your way to financial freedom.
What is Rental Property Depreciation?
Rental property depreciation is a tax deduction that allows landlords to deduct a portion of the cost of their rental property over a number of years. This is done to account for the fact that rental properties tend to lose value over time due to wear and tear. The amount of the deduction depends on the type of property (residential or commercial), its cost basis, the year it was placed in service, and the type of depreciation method used.
Over what time period can you typically depreciate a rental property?
- For residential properties (that people live in), it is 27.5 years.
commercial properties (like office/industrial buildings), it is 39 years
How to Calculate Depreciation
Calculating the standard depreciation is straightforward.
You can only depreciate the value of the building. You cannot depreciate the value of the land.
So, determine the value of the building by subtracting out the value of the land.
Then, divide the value of the building by 27.5 years for residential properties and that's the amount of gross depreciation you can take per year on the property.
For example, if you purchased a new single-family home rental property for $500,000 property and the value of the land is $100,000.
You would depreciate $500,000 purchase price – $100,000 for the land = $400,000 for the cost of the building.
$400,000 for the cost of the building divided by 27.5 years = $14,545 per year in depreciation benefits.
Cash Flow from Depreciation™
In our example above, we said that the gross depreciation is estimated to be $14,454 per year and that lasts for 27.5 years.
But, how does that get applied to me as a real estate investor.
Be sure to check with your tax advisor to see how it might apply to your specific situation since there are restrictions on being able to take depreciation based on your income, but in the meantime, here's my layman's explanation.
If you earned $100,000 per year combined from your rental properties and you job income, without depreciation you'd be paying taxes on $100,000 in income.
However, with $14,545 per year in depreciation, you end up paying taxes on $100,000 – $14,545 or $85,455.
So, in effect, you end up saving $14,545 times your highest tax bracket.
You could adjust your exemptions with your job to reduce how much tax is taken out of each paycheck. You can do this because you can anticipate this tax benefit at the end of the year. I often call the $14,545 times your tax bracket as Cash Flow from Depreciation™. That's because it shows up as extra cash flow in your paychecks from work.
Depreciation: Just One Return of Many
Depreciation and specifically Cash Flow from Depreciation™ is just one of 5 areas of return on a rental property.
The other four areas are:
The bottom half of the Return Quadrants™ (which includes debt paydown and depreciation) are the returns that are more certain and less speculative in nature. They do not require the real estate market to do well for you to receive the benefits.
For debt paydown: if you got an amortizing mortgage on the property, you will get the return from debt paydown as long as you make the regular monthly payments on the property each month until the property is paid off.
For depreciation: as long as the tax code does not change, you'll get the benefit of depreciation for 27.5 years with a residential property and 39 years with a commercial property.
The right half of the Return Quadrants™ (which includes cash flow and depreciation) plus the return on your reserves shown at the very bottom are the cash now returns.
These are returns you tend to get immediately that you can spend each month.
Depreciation in Deal Analysis
When analyzing a potential property to purchase as an investment, you can quickly and easily see how much the estimated depreciation benefit will be. Specifically you can see an estimated Cash Flow from Depreciation right on The World's Greatest Real Estate Deal Analysis Spreadsheet™. Click on the link to download your own copy for free.
Enter in the estimated value of the land as a percentage of your purchase price. Enter in your estimated Effective Income Tax Rate. Then the spreadsheet will automatically estimate your depreciation benefit. And, specifically it will estimate your Cash Flow from Depreciation™.
For example, you can see the yellow bars representing Cash Flow from Depreciation™ in the Return in Dollars Quadrant™ – Year 1 section of the spreadsheet.
Plus, you can see Cash Flow from Depreciation™ represented as a percent in the Return on Investment Quadrant™ – Year 1 section as well. Again, it is the yellow bar in the chart below.