Depreciation Basics.
Most income and expenses are very easy for investment property owners to understand. Income puts money in your bank account and expenses take it out. Simple. Depreciation, however, is different. More confusing still is the fact that we generally talk about depreciation expense in a positive light. If it's an expense then why is it perceived as good?
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The easiest way to get one's mind around the concept of property depreciation is to think of something other than real estate. An automobile, for instance, or perhaps a computer or other piece of equipment used as an example will make the concept easier to follow. Let's say we purchase a new car. When we buy it the car is worth $30,000 and that's what we pay for it. For further simplicity let's assume that we paid cash for the car. From an accounting point of view even though we wrote a check for $30,000 we don't have an expense for $30k because we still have $30k in value - in the form of a car. The $30k isn't cash in our bank any more but it's still there, sitting in our garage instead of the bank.
Most of us can now easily guess what happens next. As the days and months go by and we put miles on the car its value starts to decline. Sooner or later we look up online or in some sort of bluebook and discover that based on the age of the car and the number of miles we've put on it that it's now worth only $20k. Thru driving the car we've "used up" $10,000 of its value. This $10k is how much the car has "depreciated".
Now let's look at our accounting. We wrote a check for $30,000 but thru the effects of wear and tear from driving, the thing sitting in our garage is only worth $20,000. Today then we have a $20,000 asset (the car) and a $10,000 expense (depreciation). If next year we use up another $5,000 in value then at that point we'll have a $15,000 asset (the car) and another $5,000 expense (depreciation). This would continue until basically the car is "used up" and has little or no more remaining value. It's simply worn out.
If we were to chart this out we could see that on day one we wrote a check for $30,000 and slowly over several years we gradually "used up" this asset to where finally our annual depreciation adds up to the value of the car less any scrap value at the end of its useful life to us. The annual accounting entries of the value "used up" each year are simply our "depreciation expense" entries for that year for that item. If the item wearing out each year happens to be a business use item then these expenses are generally tax deductible.
At this point two questions may come to mind. First, this car example may sound familiar. One of the tax items most people have, certainly if you own local investment property, is mileage expense. When you total up the mileage you drive related to your business or investments what you're really doing is figuring out how much of the depreciation on your vehicle(s) in a given year is attributable to investment activity. The IRS then allows you to "expense" (or "write off" as we say) so many cents per each mile driven as part of your investment activity. For 2007 this figure is 48.5 cents per mile (see IRS notice http://www.irs.ustreas.gov/newsroom/article/0,,id=163828,00.html).
The idea behind this is simple. If a car used for both personal and business use depreciates or gets "used up" a certain amount each year the IRS wants a simple method to account for the portion of this depreciation that is business related. What they've come up with is a simple formula that says that gasoline expenses plus wear and tear (depreciation) equals 48.5 cents for every mile we drive. Obviously the actual dollars spent are going to vary by type of car but this is what we have to work with. We should note here that there are other ways as well to depreciate a car used for business or investment related activities.
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The other point that gets brought up is that if depreciation is all about a piece of equipment's value decreasing year to year due to use then how does that apply to real estate? How can you depreciate something that's supposedly going up in value!
The first thing to consider here is that real estate comes in two parts, the ground a structure (house or otherwise) sits on and the structure itself. Since the dirt is always going to be there we don't depreciate that part but what about the house? Here again an example makes this easier to follow.
If we take a vacant lot and build a house on it how can we view this house as depreciating when in all likelihood it's going to go up slightly every year in value? In our previous example we talked about wear and tear on a car from use. To make this really easy to visualize let's think of the house as suffering from neglect instead of simple use. What if we built a house and we were an eccentric sort of person and never rented the house out, never lived in it, and literally never touched it after it was built. After a year or two the yard becomes something of a jungle. Somewhere along the line a storm hits and damages the roof and/or some windows. Pretty soon Mother Nature makes her way inside the house and the cabinets start to decay and the carpets rot. Slowly but surely the whole house begins to decay until one day, many years from now, the house is simply gone.
This is an extreme example and not an entirely fair one but it helps show how the structure "wore out" like our car example above. Year by year our house (the structure at least) became worth less and less until one day the only value left in the property was the land itself. Our property depreciated (except for the land) until gone.
The truth is that any house, whether maintained or not, is going to slowly wear out until the day comes that it is replaced or simply torn down. Yes, there are homes hundreds of years old. Yes, some become protected landmarks. Yes, even a basic house is likely to outlive us, but the concept that a house eventually becomes outdated and of little value as a livable structure is what depreciation is all about. "Depreciation expense" is the accounting for this eventual wearing out.
For purposes of tax accounting here in the U.S. we "wear out" on paper (or depreciate) a house over 27.5 years. So if a property is worth $200,000 and $50,000 of that value is land we can depreciate the remaining $150,000 (the structure's value) over 27.5 years. In this example this would work out to approximately $5400 in depreciation expense every year. The first year would depend on the month you purchased it but the subsequent years are very nearly the same from year to year. The IRS publishes a handy chart to track depreciation here.
So what if the house you just purchased as a rental is already 10 years old? Do you only have 17.5 years left to depreciate it? The answer is "no". The clock starts ticking again from scratch when you bought it (and made it available as a rental) even if the house is already 50 years old! You may see now that this is a handy expense to have. You didn't really write a check for it yet it came off your taxable rental income. Even though it's very likely your property is going up in value you continue to write this expense off year after year. Indeed this is one of the strong points of real estate investing!
The last thing we should note is that, on investment properties, this depreciation is not optional. It is a mandatory expense per the IRS. It also gets "recaptured" when you sell your property. When purchasing a investment property you should definitely consult a tax professional to get the whole picture. You may also be able to accelerate some of this depreciation thru the separation of Chattel. -back to tutorial index-
