Deducting Depreciation

Many beginning investors are initially perplexed about the concept of depreciation , particularly in the area of real estate. How can you depreciate the value of real estate when its fair market value continues to increase?

For example, Lupe buys an apartment building for $500,000, with the underlying land worth about $100,000. The building itself, apart from the underlying land, would thus be valued at $400,000. Lupe deducts about $10,000 in depreciation every year for the building, reducing her taxable income by that amount. Nevertheless, within ten years (after depreciation more than $100,000) Lupe's apartment building has actually gone up in value to $800,000.

Depreciation is the periodic expending of the value of an asset over that asset's useful life. Depreciation is a difficult concept for some to grasp, because it seems like an "imaginary" deduction. Depreciation is based on projections of useful life, but these projections are by nature always inexact. We can arrive at worthwhile projections about the useful life of any equipment, fixture or even building, by examining the past. But the projections are just that, projections. For example, we can understand from experience that a fax machine may have a useful life of four years; but there are many people who have fax machines that are more than seven years old.

With regard to real estate, even buildings have a useful life. Normal wear-and-tear will gradually degrade the building. Such useful life can be extended through rehabs, improvements and upgrades, but there's no stopping the ravages of age. Depreciation is the accounting and tax method for considering the cost of such wear-and-tear on an asset.

Nevertheless, there are many examples of real estate continuing to increase in value even while its useful life is coming closer to an end. But property value and useful life are not always connected. Property value is more often a consequence of increasing demand and limited supply.

Real estate investors who grasp the concept of depreciation deductions quickly realize its benefits and advantages. Even investors who do not fully grasp the concept still appreciate the tax benefits of depreciation deduction. This review will review the requirements and guidelines for real estate depreciation deductions:

  • Investment property
  • Calculating depreciation
  • Recapturing depreciation
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