Sunday, February 20, 2011

A Straight-Line Depreciation Schedule

Since it's tax time, I wanted to give you a simple explanation for what may seem like a complicated topic.  Depreciation is the IRS's definition for real estate incurring wear and tear as time goes on; in fact, for tax purposes, the IRS allows you to assume that your real estate will be totally worn down and useless after 27.5 years for residential investment property.  Here's how you calculate depreciation:

If you buy a home for $100,000, subtract out the value for the land since even the IRS knows that dirt doesn't wear out.  A liberal valuation for land would be 10% of the purchase price.  So $100,000 - $10,000 = $90,000.  So we're depreciating $90,000 over 27.5 years, this would be as follows: $90,000 / 27.5 years = $3,272 / year.  This amount you can write off as a deduction against the cashflow of your home, essentially allowing that income to be tax-free.  So if you have a home and you earn $200 / month positive cashflow, or $2,400 per year, you can not pay tax because you have $2,400 in income, with a loss of $3,272 in wear and tear.  So $2,400 - $3,272 = -$872.  Guess what?  You can now take the remainder of this "loss" against your personal earned income from you JOB!  So now you just sheltered $2400 in rental income, plus $872 in earned income, and you didn't even have to spend the $3,272 to get the write-off because depreciation is a NON-CASH EXPENSE!!!

Now imagine if you had 5 homes depreciating at $3,000 per year...imagine if you had 20?  Would you pay any income tax on your earned income?  Would the government actually have to write YOU a check in your depreciation exceeded your earned income!?

Any questions?

4 comments:

  1. thanks for the insight --

    no comment on shannon's comment

    ReplyDelete
  2. also. . . you DO have to pay a big tax bill whenever you end up selling the house, correct?

    ReplyDelete
  3. Julian-
    The recapture tax rate is 25% of whatever depreciation you've taken prior to selling; however, there are 2 ways to avoid this!

    1. Do a 1031 Tax-Deferred Exchange and roll over your entire capital gain TAX-FREE into your next investment property! Consult a professional like myself before doing this...
    2. Die! Your basis in the property is automatically stepped up to the actual fair market value and all depreciation taken is WIPED OUT! How great is that?

    ReplyDelete