I have been preaching for years the tax advantages of owning rental real estate. However, many investors do not understand most of the tax advantages, especially depreciation. Hence, a brief explanation of what depreciation is and how it works.

What is Depreciation?

Depreciation is an income tax deduction that allows a taxpayer to recover the cost or another basis of certain property placed into service by the investor. Depreciation is a non-cash deduction that reduces the investor’s taxable income. Many investors refer to it as a “phantom” expense because they are not actually writing a check. It is merely the IRS allowing them to take a tax deduction based on the perceived decrease in value of the real estate.

Depreciation assumes that real estate is actually declining over time as a result of wear and tear. But we know this is not typically the case. Not many other forms of investment offer comparable depreciation deductions. As a result of depreciation, the investor may actually have cash flow from the property but may show a tax loss. The benefit, of course, is to lower the overall tax liability.

In order to be eligible for depreciation, the property must meet certain requirements:

• The taxpayer must possess the property and may also depreciate any capital improvements for property the taxpayer leases.
• The property must be used in a business or income-producing activity. If a property is used for business and for personal purposes, the taxpayer can only deduct depreciation based only on the business use of the property.
• The property must have a determinable beneficial life of more than one year.

A Tighter Look

First of all, land is not depreciable. But assuming you have rental real estate, you can depreciate the building, significant improvements, and any equipment that is used in the operation of the property. Depreciation begins when a taxpayer places property in service and ends when the property is disposed of or otherwise retired from service. Any depreciation that was taken will reduce the investor’s basis in the property. Upon disposition of the property, this depreciation is essentially recaptured.

The actual depreciation calculation is not too difficult. For a real estate purchase, the total purchase price should be allocated between land and building value. Since land is not subject to depreciation, the building would be depreciated over the IRS prescribed useful life. This life is designated as 27.5 years for residential rental property and 39 years for commercial property.

Depreciation is a critical tax deduction and should not be overlooked. It is important for the real estate investor to understand the basics of depreciation. This will assist the investor with tax planning and help them understand after-tax investment returns.