Real estate depreciation for is very confusing for most people. But, in this article, I will explain the depreciation act to you in the simplest form that an 8th-grade kid can understand. This real estate law is mainly used for tax savings.
- As you know, in real estate ‘taxes are the biggest expenses an investor has.
I will share how you can reduce your real estate tax near zero using the depreciation act.
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What is Real Estate Depreciation?
As I have said earlier, it’s a way to reduce your capital gain tax through the law. But, there are some rules and regulations that you need to follow before you apply for depreciation. Here is the formula:
- Depreciation of real estate = (Total asset value – Land value)/ Depreciable years
I will explain this later in this article, but first, have a look at the rules and regulations the government has set up for us.
Rules and Regulations of Depreciation
You must follow these rules to qualify for real estate depreciation.
- Hold the property for a long time, about 27 years for residential and 39 years for commercials. You can not sell it before that time period.
- Hire a certified accountant to calculate the depreciable amount accurately.
So let’s calculate how to use real estate depreciation to reduce your property taxes.
Real Estate Depreciation Calculator
Now let’s imagine you have a big multifamily house with 500 units. The total asset value of the building is $19.7 million. That building is generating $2.2 million as rental income, plus some extra income of $500,000 from:
- Parking facilities
- Washer and Dryer
- Children park
- Swimming pool
- Common room
- And other special services
I am taking some big numbers here. So you can tell the difference easily.
After analyzing the building, you saw the total expense is $1.5 million per year. So your Net Operating Income (NOI) will be $1.2 million. Because:
- NOI = Total Income – Total Expense
- NOI = ( Rental income + Extra income) – Total expenses
- NOI = ($2.2M +$0.5M) – $1.5M
- NOI = $1.2 M
Now deduct the loan amount you took to build that building, and that is $900,000 (assuming). So your new NOI will be:
- NOI = $1.2M – $900,000
- NOI = $300,000 ( that is your cash flow)
Now, that $300,000 is your income from that building, you have to pay tax on it, which varies from 15% – 30%. Lets say 30%, which is the maximum. So your property taxes will be:
- Tax = $90,000 (OMG that is huge)
You can see you are losing $90,000 as taxes which you can use to build another house, a total waste. Now let’s see how you can save that money with this real estate law.
An Example of Depreciation in Real Estate
You can see your new income is $210,000 ($300,000 – $90,000). But if you can show in the paper that you have no income at all, then you can be saved from the taxes. How? Let’s use another example to save more and more taxes. The depreciation formula says,
- Depreciation = (Total asset value – Land value)/ Depreciable years
- Depreciation = ($19.7M – $3M) / 27.5 years
- Depreciation = $607,272 (take it as $600,000 for round figure)
We are assuming the value of the land is $3M. In depreciation, they don’t calculate the land price because land never loses its value, only the building, and objects inside it.
The laws only apply to depreciable items, not something like land. That’s why they are deducting the price of the land. So your new taxable cash flow is:
- New cash flow = $300,000 – $600,000
- New cash flow = – $300,000
Your cash flow is negative. You are losing money. So how can you pay tax on it? You don’t have any income at all.
- Before you were paying $90,000 as tax for your $300,000 income, but now you are paying $0 as taxes because you have no income.
Why The Government is Allowing This?
The sole reason for that kind of real estate law is that the government wants more affordable homes. They want to boost the housing market. That’s why they are giving you some concession to invest in a house.
This law is built only long term investment. You can not sell it between that time, and that’s what the government wants, an affordable house for its citizens.
Save More Taxes Using This Depreciation Law
As you know, tax is the biggest expense for real estate investors. So how are you going to reduce it? There are various laws that you can use.
- One of them is the 1031 tax exchange applicable in the USA.
There is a similar law in every country. In India, it’s section 54, I think. You can check if your country allows these types of practices.
So, the exchange law says you can defer your capital gain tax if you invest the whole amount in a separate house. That means you don’t have to pay any capital gain tax, which is 20%.
Because the government wants to have more property investment, more houses, and more employment. That is why they are giving you the concession to invest.
Tax exchange law is just one example of many tax codes. Contact a good tax advisor to apply these correctly. He will tell you everything you need to know to reduce your real estate taxes.
I am not an accountant or a lawyer. Please consult a legal and tax expert before you apply for real estate depreciation. It is a legal thing. Any mistake can damage your investment. So be careful while applying.
If you are a rental property investor, you should apply the property depreciation act to reduce your taxes near zero. So this is what real estate depreciation is. I have explained this in the simplest form possible. If you have any doubts, you can leave a comment below, and I will make sure to help you out. Thanks for reading.
How do you calculate real estate depreciation?
Calculate depreciation using this formula, Real estate depreciation = (Total asset value – Land value)/ Depreciable years.
What are the rules for using depreciation?
You must hold the property for about 27 years for residential and 39 years for commercial. You can not sell it before it.
Can you give an example of property depreciation?
You can reduce your property taxes as low as zero using this depreciation rule, like before you paid $90,000 as taxes for your $300,000 income to paying $0 as taxes as you have no income on paper.