“Simply put, depreciation lets you keep more of your money.”
Real estate has some incredible benefits over other types of investments. Some of these benefits involve keeping more of the money you earn from it by reducing the taxes you have to pay. These aren’t creative loopholes, or things you have to worry about justifying in an audit. These are clearly written right into the tax code, and the IRS expects you to utilize them.
One of the greatest of these tax benefits is depreciation. Depreciation may not sound like a benefit if you’re new to real estate investing. People often think of depreciation as an item losing its value, like a new car or equipment. Besides, real estate is supposed to appreciate. That’s one of the main reasons people like it so much.
How does depreciation work in real estate?
The IRS assigns a “useful life” to assets. If you buy a piece of equipment that has a useful life of 10 years, you write off the cost of that equipment over the 10 years. The IRS assigns a useful life to real estate as well. That useful life is 27.5 years for a residential rental property, and 39 years for a commercial property.
This useful life has nothing to do with the value of a property, and the property isn’t required to lose its value over it’s useful life. The IRS figures if you buy a commercial property, it will be useful for 39 years without any capital improvements. If you don’t repair the roof, update electrical or plumbing, or anything else to extend it’s life, that’s how long they expect it to survive. They also assume a residential rental property will make it up to 27.5 years without any capital expenditures.
This means that you can write off the purchase price of commercial buildings or structures over 39 years, or a rental property over 27.5 years. You simply divide the purchase price by the years of useful life, and deduct that amount on your taxes each year.
Commercial property: $1,000,000
39-year depreciation: $1,000,000 ÷ 39 = $25,641 per year
How does depreciation benefit real estate investors?
Most tax write-offs require you to spend money. If you spend money on advertising, you write it off. If you pay for lawn care, you write it off. Depreciation, on the other hand, isn’t an actual cash expense. It’s deducted from your income, but doesn’t actually change the cash flow. This means you keep more cash at the end of the year.
Depreciation can significantly reduce your tax liability. Let’s look at an example.
Purchase price of a commercial building: $1,000,000
Annual depreciation: $1,000,000 ÷ 39 years = $25,641
Net Operating Income (NOI): $60,000
Taxable income: $60,000 – $25,641 = $34,359
This means you’re only paying taxes on $34,359 instead of $60,000.
Let’s say your tax rate is 32%. That’s over $8,000 in tax savings. You essentially just added $8,000 to your total return.
What about capital expenditures?
You’re most likely not going to allow your property to sit for 27.5 or 39 years without making any major repairs or improvements. While some improvements qualify for Section 179, meaning you can write off the total cost in the year the improvements were made, most capital expenditures are an improvement in the real estate.
Smart investors factor in a capital expenditure reserve when they calculate their total return. This is an amount that’s usually set aside from the rental income each month. This way the cash is available when it’s time for a major expense, such as a new roof or parking lot.
These repairs are then added to the depreciation schedule. This means more non-cash expenses to write off each year.
Let’s say that $1,000,000 property needs $50,000 in structural repairs. You now get to write off the depreciation on that. Later on you spend $200,000 to increase the size of the building to accommodate a new tenant. Now you’re depreciating that each year.
You’re continuing to extend the useful life of the property by making necessary repairs. However, this doesn’t change the fact that the IRS is still letting you depreciate the real estate. Your property is most likely appreciating in value, while you continue reducing your tax liability.
How does depreciation build wealth?
To find out how to use the benefit of depreciation to build wealth in real estate, the best thing to do is ask one of the most successful real estate investors in the world how he does it.
Grant Cardone, CEO and founder of Cardone Capital, has been able to use the tax advantages of real estate to multiply his wealth over and over again.
Cardone explained it like this. “If you make $100,000 a year at your job, you’re giving the federal government 22–24% of that and, depending on what state you live in, you may be giving up another 5–13% in state income taxes. That means you might only end up with $65,000 of your money.”
“If you make $100,000 on a real estate investment, you’re only paying taxes on $50,000–$60,000 of that income because of depreciation. That takes your $35,000 tax bill and reduces it to $20,000. In reality, it will probably be even less because you’ll be in a lower tax bracket.”
You may be thinking that a difference of $15,000 isn’t going to create any significant wealth for anyone. Cardone explains how it actually does. “At Cardone Capital, we target a return for our investors of at least 15% between cash flow and appreciation. If you invested that $15,000 each year in real estate with me, you would have $1.8 million after 20 years.”
The truth is, if you’re generating income from real estate, you’re going to earn a lot more than an extra $1.8 million in 20 years. Cardone said, “Look man, I have $1.8 billion in real estate assets under management. If you can learn how to take advantage of all of the benefits of investing in real estate, like depreciation and leverage, there’s absolutely no reason you can’t do the same thing. I wasn’t born with a silver spoon. We were broke. My first deal was $78,000, and I only put down $3,500. I was barely able to even get a loan on the deal. I’m proof that anyone can do this.”
Cardone Capital is a private real estate company that allows passive investors to partner with Grant Cardone on his real estate deals. They also provide a lot of useful information for real estate investors, such as how to buy a duplex or analyze a rental property.
The bottom line
Simply put, depreciation lets you keep more of your money. No other type of investment allows you to keep as much of your profit as real estate. The IRS isn’t going to let you depreciate the cost of your stocks or bonds, and you definitely can’t depreciate the cash sitting in your savings account.
You also don’t have to be a hands-on landlord to invest in real estate to take advantage of the tax benefits. Some investors choose to hire a property manager, and others choose to invest more passively with companies like Cardone Capital. However you choose to invest in real estate, you’ll be glad you did it.