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How Depreciation Works
With running a rental property business, or any type of business for that matter, you are allowed to deduct expenses incurred for operational activities from the revenue for tax reporting.
Some of these expenses include common things like:
- Interest on loans and credit facilities
- Insurance premiums
- Office supplies
As an investor or business investing in capital assets, you are entitled to deduct the costs from the Profit and Loss statement as well.
But these items cannot be fully deducted in the year that it was purchased. They enter a recovery period and will be depreciated over a set number of years.
To avoid confusion, there is a clear distinction between expenses and capital assets.
Expenses are the costs of running a business during the financial year.
Capital assets have a useful life that can stretch for several years and even decades. They retain value throughout the course of these years. Slowly depreciating year by year according to a predetermined schedule until it has zero value left, ready to be written off in the books.
At this point, it is important to note that depreciation is not a unique feature that only exists in real estate realms.
Any type of business will have depreciation to contend with. Common items include vehicles, equipment, printers. etc.
Also, don’t be confused with amortization and depreciation. They mean the same thing except that the former refers to non-tangible assets with value while the latter refers to tangible physical assets.
The depreciation accounting guidelines allow businesses to properly segment capital assets into categories and claim depreciation against their profits.
In real estate, acquisition of properties, houses and apartments cannot be bracketed as a business expense. These are investments on capital assets.
Even improvements made to a house for example new roofs or new extensions will last for a number of years. And therefore, be depreciated.
The reason why depreciation is such a buzzword in real estate circles is because of it’s positive effects towards cash flow.
Being recorded as an expense item without actually costing the company real money, it effectively allows the company to “pocket” the extra cash as cash flow. The favorable tax effects will only double the happiness.
For example, if you booked a profit of $10,000, after deducting a depreciation expense of $4,000, you will be left with $6,000 profit.
This implies that out of the $10,000, only $6,000 is taxable.
$4,000 has disappeared in your books while in reality, the money is sitting in the bank account.
Also take into account that real estate are very highly valued assets. So depreciation for rental property businesses will understandably incur significant levels of depreciation expense.
Depreciation in real estate
With the exception of land, all capital assets including real estate is eligible for depreciation.
For example, if a property is bought for $250,000 which land value makes up for $50,000, only $200,000 is applicable for depreciation.
The land worth $50,000 however, can still be carried on the balance sheet as an asset.
An important point to note is that when calculating depreciation, the purchase price of the property is always used as the base value. Using the property value is incorrect and might get you into trouble with the IRS.
For example, if a house was acquired for $100,000 10 years ago, the depreciation schedule will still be based on the $100,000 initially paid for it even though it is worth double that in the current market. This does not take into account the value of land which might be deducted from the $100,000.
With the details discussed above, it should now be clear that the recovery period implemented for the depreciation schedule will be instrumental in determining annual depreciation expense.
This is because the straight line method, which is the most common method of accounting for depreciation allocates the same amount of expense each year.
Using the specified recovery period, the total amount is divided by the number of years accordingly to finalize a yearly amount.
This means the the shorter the recovery period, the higher the annual depreciation. And the longer recovery period resulting in a lower depreciation.
Working out the recovery period will require the advise of your accountant or tax advisor. Be mindful that there might also be guidelines set by government agencies regarding the perimeters you are required to work within.
Depreciation only starts when asset is placed in service
Accounting for depreciation is painlessly simple when an asset is used solely for investment purposes.
In this case, you can use the purchase date to start working out the numbers, and even pro-rate if necessary, to tabulate how much can be claimed as a legitimate depreciation expense.
However there is a rule which states that depreciation only starts when you first use the property in your business or for the production of income.
This in effect means that even if you bought some heavy machinery for use in the business last year, you can only start deducting depreciation this year if the asset is only placed in service this year.
Depreciation for pure investment real estate
For assets, including real estate, that are acquired exclusively for investment purposes, calculating depreciation is as straight forward as it can get.
So long as you have kept proper documentation of the date when you acquired the assets and have a clean bookkeeping system in place, you can start preparing the statements to claim for depreciation expense.
However, do keep the previous point regarding when it was first placed in service into consideration.
Partially used assets
One of the perks of running your own business is that you can make personal use of company property… quietly and discreetly charging your personal expenses to the company.
But depreciation deduction claims for these items will greatly depend on how they are used.
Let’s briefly identify some of the most common depreciable company assets that’s heavily used for non-business activities.
Keep a log of mileage, purpose of use, date, commencement and end time of trips, etc.
Keep a log of purpose of use.
Keep a log on usage purposes.
Renting out a room
Area of rental space in square footage compared to the total square footage of the home.
When assets are partially used for investment purposes, fair calculation is used to determine the portion of business and personal use.
Depreciation will then be applied accordingly to the portion for business use.
Difference between expensing and depreciation
Expensing is a term that is closely related to depreciation.
It is common accounting practice for businesses to expense capital assets as opposed to depreciating them.
In the same vein, assets can be written off via expensing in the work year they are placed in service. However, this is also subject to allows annual limits.
For a business owner, there can be tax benefits to expense off capital assets rather than to depreciate them instead.
Expensing is only allowed for businesses. Not for real estate investors.
However, there might be every chance that you are both a business owner and real estate investor.
Let’s say a company vehicle you’ve purchased is used for both the business and real estate investing activities. Putting it firmly into a mixed use asset class.
If the usage is evenly spread between both operation, then you might want to expense it on the side of the business and depreciate it on the other side of real estate investing activities to claim the maximum expenses allowed.
This is because there are limits to how much you can claim for depreciation and for expensing.
Exploiting both is what a proper tax advisor should inform you about when doing tax planning.
This also means that if you want to do more expensing than depreciating during the year, be smart and use the vehicle more for the business than for real estate.
Don’t think for a moment that you can depreciate your way to great wealth. Because uncle Sam is not stupid.
When you sell a property that you have depreciated over the years, the value depreciated will be recaptured when calculating capital gains tax.
This is a reason why some investors strongly advocate never to sell your investment properties.
All in all…
… Remember that there are various factors that can determine the success or failure of landlording businesses.
While depreciation is sometimes marketed as a key element or gamechanger by real estate coaches, be mindful that there are also many limitations of it.
For example, if you are using your house as a home office and have the genius idea of claiming depreciation, think again. Because you need to be using a space 100% of the time exclusively for business use in order to claim depreciation. And even so, the amount will be an equal ratio of the business space to the total living space in the house.
When in doubt, always consult a tax advisor or the IRS directly.
While it is critically important to understand how depreciation works in the world of real estate businesses as a landlord, it is also vital to understand that it will seldom make or break your business.