Depreciation is a non-cash expense which has the ability to reduce the amount of tax payment due. We have likely all heard the term before, but how exactly does it work? How can it help us to reduce the amount of tax we pay each year?
Let’s use an example. Say you purchase a rental property for $100,000 and let’s assume the value of the land which comes with this property is $10,000. The means the ‘basis’ value of your building is $90,000. Rental property buildings can be depreciated over 27.5 years. So, if we take the $90,000 and divide by 27.5, the result is $3272 of depreciation.
Next, let’s make some assumptions about how this depreciation might be used each year. If the rental property produces $100 of cash flow per month (after all expenses), this would mean $1200/year in rental income, right? This $1200 of income would (if you qualify) be offset by a portion of the depreciation, thus making your $1200 of rental income non-taxable.
So, if we started with 3272 and we used $1200, we are now left with $2072 is depreciation expense. This remaining depreciation can then be applied to offset your other income. Depending on your tax bracket (10-35% in 2009), you would calculate your additional net tax savings.
As you build a portfolio, you can see how this could make a significant impact in the amount of take home income you actually get to keep. There is a reason why many of the world’s wealthy individuals own real estate. It provides a non-cash deductible, which can be extremely powferful for building and KEEPING wealth.
There are IRS limitations and you must ensure that you qualify for the deductions.