Today, we’re going to talk about depreciation in Real Estate. Is it as bad as it seems? Is it really as bad as some people think it is? If you don’t know what depreciation means, it just simply means the loss of value of an asset due to changes in the market condition or due to wear and tear.
If you bought a house and it was worth $100,000 but then the market has taken a downturn and all of a sudden, things went downhill and now, that house, instead of being worth $100,000 is now worth $50,000.
It starts to wear down because you are using it so due to the wear and tear, then you start stripping sort of the value of the property all the way down until it gets to zero. On top of that, you were probably thinking, well, that’s a horrible thing, but let’s just face it. Everything wears down, everything cannot stay new forever and because of this, the US tax code actually takes that into consideration when you’re using the properties or any type of assets for the purpose of business.
Depreciation in Real Estate: The depreciation time of a house
Let’s you recently bought a house in 2021, it costs you $100,000 and you’re ready to put that up for rent and at the end of the year, you’re filling for your taxes and your accountant says: So you bought this at $100,000, let’s just start depreciating the value of this property.
What your accounting is going to do depending on the type of property you have and the depreciation time it has, (the depreciation for a single-family home is 27.5 years). You have $100,000 and then your accountant is going to multiply this by 27.5 and that means that your depreciation amount is going to be $3,636. For example, you bought this house and you decided to rent that out for $1,500. That’s the market rent that most people are willing to pay for this one family home.
You multiply $1500 by 12, that means that on a yearly basis, you’re going to make $18,000. You have $18,000 in annual rent. What would you prefer to do? Would you prefer to take $18,000 and pay whatever tax rate you have? Tax rate, or do you want to take this amount and source of depreciation into account and then reduce this $18,000 minus 3,636 and pay taxes off of, let’s say $14,363.
Now you’re noticing that depreciation in Real Estate is not necessarily a bad thing, it’s actually a good thing that it’s going to work out to your advantage if you were to account for the wear and tear of a property, and you can do that, not just with houses, you can actually do that with buildings. The depreciation rate is 39 years.
You can actually do that with equipment that you’re actually utilizing for the purpose of your business. Now you’ll probably be wondering, “Okay, that sounds great, but does it only work for rentals?” The answer is yes. It only works if you were to hold the property for over a year.
If you are a flipper and you are reading this, you will not be able to do that because typically, when you’re a flipper, you buy a property in a poor condition, then you flip it, you make it look really nice and the goal is to sell it before the year ends. The goal of flipping is to bring the value up so you can actually make a profit out of it.
Depreciation in Real Estate: Old houses
It will not work out for you if you are a flipper. Now, another question that you might possibly have is, “Okay, I have a house, and the house is 100 years old. Does that mean I won’t be able to take depreciation off of it?” The answer is no, you will still be able to take depreciation out of the house that you bought for rental purposes. Why? Because depreciation starts from the minute that you’re putting that asset to that business. Even if the house is 100 years old, but you’re buying it, right now in 2021, depreciation is starting off in 2021 because you are renting that property out exactly in 2021, and then you add 27.5 years so you have all the way until 2047 and June, six months more to take full advantage of the depreciation.
There are multiple ways to do depreciation in Real Estate. There are other techniques that are more advanced. You should reach out to your accountant and get the most information you can to see if this is something that will work out for you or not.
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