Depreciation is an artificial concept in the real world, but very real and practical for your bottom line when you file your taxes. Depreciation is a CALCULATION of how an investment property loses its value over time.
Real estate is of course an asset (defined as something having ongoing value) however, in accounting, this real estate can potentially lose its value over time.
A simple example is a car. The price you pay for a car is your cost, but its market value decreases every day (excluding collectibles) even though the car too is an asset under accounting rules.
Simply put, your car is actually depreciating in dollars and cents, but for accounting purposes your real estate does as well – even if it is actually going up in value!
When starting in real estate every investors asks a CPA the same question, “Real estate never goes down in value so why do we have to calculate this depreciation expense?” Investors very quickly learn that this is a silly question because this “expense” is actually a huge savings since it drastically decreases your taxable profits!!
In order to obtain financing to invest in properties you must have sound financial reporting. Banks and all types of lenders require detailed financial information from investors via financial statements. If you own properties personally, this would be shown through your standard tax return.
Lenders understand that depreciation is irrelevant for actual deal calculations and look to the true market value of the properties you are discussing with them. You must always remember that accounting is separate from the real world.
Here is a simply breakdown of how depreciation works for a real estate investor.
Tax rules state that the useful life of residential property is 27.5 years
Step 1: Separate the land value from the structural value – the underlying land is never depreciable
Step 2: The remaining value (total Value- land value) = depreciable amount
Step 3: The depreciable amount is now divided by 27.5 years and taken as a deduction (write off) again your gains in that property for the tax year.
Step 3a: If you are investing in commercial properties the useful life is 39 years.
Step 4: Personal property (appliances, furniture, fixtures etc.) can also be allocated in the calculation but those rules are mindbogglingly complex so I will leave that for another post!
Step 5: Relax, this is what your CPA is for, but it is vital to understatement basic accounting as an investor so you can calculate your deals correctly!
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