on Feb 9th, 2008What is Depreciation? And why is it important to understand?
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One of the first questions that comes up when people start talking about real estate investments is the tax advantages of being able to depreciate the property year after year. Most people question why you can depreciate an investment property, since real estate as a whole generally appreciates (goes up in value) over time.
The short answer is that when you own a piece of real property, whether as an investment or as a principle residence - you actually own two individual assets: the land, and any improvements (buildings). The land - goes up over time and generally carries the improvements with it. But since they are susceptible to wear and tear, maintenance, upkeep, etc. - the buildings will depreciate over time, and the government allows you to write this off on your taxes to reflect this.
So what exactly is depreciation?
In the strict sense of the word, it is a loss of value from any cause. Generally it is referred to as a percentage figure of the total initial value of the property (the value at the time of acquisition - most of the time this is the purchase price of the whole property, less the value of the land only). For example, you might say that a building is 20 percent depreciated.
On a real property, the loss of the value comes from three main causes - or a combination of the three:
- Physical Depreciation: This comes about from natural wear and tear on the building itself. Shingles need replacing, metal tends to rust, paint tends to crack, water damage can occur. etc. As these items wear, they will need to be replaced.
- Functional Obsolescence: This is an impairment of the desirability of the property. For instance, a house with only one bathroom isn’t as desirable in a neighborhood where everyone else has added a second bathroom or more. Or maybe the house is of a different style, or has an interior or exterior that is no longer in fashion. It can also occur due to changes in building processes - for instance if one house is still on a well or septic, while all the other houses in the area are on public water and sewer. All of these will reduce the over all value of the house and depreciation will reflect this.
- Economic Obsolescence: This is very similar to functional obsolescence, but is usually due to outside forces - and thus has nothing to do with the age or design of the home. An example of this is a change in zoning around your property that will make it less desirable for the use it is intended. You could have a home in like new condition that is immaculate in every way. But if the county just announced they are going to put a prison on one side of the property and a dump on the other, then your property will go down in value.
Depreciation is a way of accounting for the expected repair or replacement of an asset due to its reduced value for any of the above reasons.
So why can you depreciate an investment property but not a personal residence?
Well, when you buy a property for investment purposes, you are actually buying a business asset. The land and its improvements are to you - what a factory and an assembly line are to General Motors. Or what a brand new computer server is to Microsoft or Google. Or what an oil tanker is to Exxon. And just like those business assets, your property is going to depreciate in value.
Since depreciation of an asset (any asset) is a legitimate and real business expense (since all assets will eventually have to be repaired or replaced) the IRS allows you as the investor to deduct it from your taxes as a business expense - even though you never actually paid out any cash for that expense.
This is one of the biggest tax advantages of an investment property, especially during the first few years. Depending on the interest you’re paying on your mortgage, the depreciation method you choose, and the rent you’re collecting - it is usually possible to make money on the rental property, but not show any income from the property.
We’ll discuss all the tax implications of real estate investing at another time.
