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Depreciating Your Real Estate Rental Property

Don't Forget to Take Out the Land

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If you came to this article in a search, it is part of our Rental Property Investment Analysis. Start there to walk through a detailed analysis of a sample property.

In our series on Rental Property Investment Returns, we're using an example fourplex as our investment. You can get the purchase details here, however, remember that it was a $325,000 purchase of a fourplex for rental of all four units full time.

Always check out all tax issues thoroughly with a tax accounting professional, however the IRS generally will allow us to depreciate the value of the structure on this property over a period of 27 & 1/2 years. This is the logical treatment of the fact that buildings do wear out over time, or become obsolete due to their older features no longer in demand.

So, we have a property that is generating $15,192 per year in positive cash flow, but now we can offset some of that income for taxes. We depreciate the building by deducting out the value of the land and dividing the building value by 27.5 years for annual depreciation. The depreciation calculation looks like this:

1. Purchase price - Land Value = Building Value.
2. Building Value / 27.5 = Annual allowable depreciation deduction.

For our example fourplex, we'll assume that the value of the half acre on which it sits is $80,000. Now let's look at our calculation:

1. $325,000 - $80,000 = $245,000 Building Value.
2. $245,000 / 27.5 years = $8909 per year in depreciation.

Without taking any other property tax or mortgage interest deductions into account, we've already reduced our taxable income. As we want to look at tax aspects of our property, we're adding back the prinicipal and interest in the mortgage payments we subtracted for the cash flow calculation. Thus our $15,192 cash flow goes back up to $34,908.

$15,192 + $23,316 - $3600 taxes & insurance = $34,908. This is the potential tax liability for the direct rental income less taxes, vacancy loss, insurance, repairs and direct expenses. We'll look later at other deductions. But here is how the depreciation backs out.

  • $34,908 - $8909 depreciation = $25,999.
  • Remember that we didn't spend any money to realize this deduction. And we still have other deductions to take. The payment isn't in the calculation yet, as we have to break out interest from equity. It isn't a totally free ride on this deduction either. When you sell the property, you will have to take these depreciation deductions into account when calculating capital gains for taxes. However, there are ways to overcome those taxes as well with a 1031 Exchange.

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