When we speak with real estate investors today who want to buy investment property in Memphis, they are almost always attracted to the concept of positive monthly cash flow and rarely look at other signature pluses of real estate such as appreciation, equity and almost never depreciation. The last one is one of those terms and concepts that comes across as so technical that many fail to realize exactly how crucial and beneficial it can be!
Capturing depreciation on your investment property is a perfectly legal way to reduce the tax burden of an income producing investment property in it's current year and simply defer that tax to a later date. Notice, I did not say that the depreciation makes the tax burden go away. It simply allows an investor to keep positive cash flow from the current year by taking a line item expense for normal wear and tear on a property.
If you found, that confusing...I will say to consult a great CPA who understands real estate investing like Jimmy Luke here in Memphis (ask me for Jimmy Luke's information) and then continue reading. I'll try and clear it up a little bit.
Depreciation is a concept created to assist investors with the fact that property does suffer normal wear and tear over time. This is on top of any repairs or updates that may have been made to the property. Depreciation takes into account that the physical property will slowly over time begin to wear down and it allows an investor to deduct that wear and tear as an expense. So no money actually goes out, it is a phantom expense line on your tax return.
This depreciation allows an investor to reduce their current years income on the property and all deprecation is added back to the cost basis of a property when it is sold. Since a majority of our investors are looking for long term buy & holds and want to maximize monthly cash flows on their properties for quicker pay off, it makes sense that most want to capture as much depreciation as possible.
The most common way to calculate depreciation on a real estate investment property is straight line depreciation which takes the value of the property at purchase and depreciates that property over a set period of time and the same amount each year. There are many ways to depreciate the value of certain assets related to real estate, but for the value of the property itself, the straight line method is the most common.
So this deduction that you are allowed to take each year directly reduces the amount of income you made on the property in that calendar year and therefore lowers your taxable income. When you have built a portfolio and have many properties, this reduction can be significant!
I would encourage you to seek the advice of your CPA or the advice of my CPA, but they will all tell you that depreciation is a fantastic benefit that the IRS allows for real estate investors.