Depreciation

[inquisitive]

Help me to understand the concept of depreciation. Since you have to pay taxes on the total amount that you depreciate at the end (eg, a house), how does this save any money? Is the idea that you have all of those years to invest the money so that at the end when the property is sold you have more than recovered the difference even if you are in a higher tax bracket?

 

[RedHawk]

Depreciation is related to the "matching principle" in accounting. The objective of this principle is to recognize related revenues and expenses in the same period (usually each year). For example, if you own a rental property that produces income, you recognize the "expense" of the property each year through depreciation. Therefore the income (rent received) and expenses are recognized together.

A depreciation deduction today has tax benefits since it reduces your tax liability today. Although you might have to pay it back in the future a dollar today is still worth more than a dollar in the future.

 

[Nords]

Although you might have to pay it back in the future a dollar today is still worth more than a dollar in the future.

Unfortunately for some of us landlords, today's depreciation is reducing the number of dollars that are taxed at 15% and recapturing them (when the property is sold) at 25%. But planning a tax strategy around that requires educated guesswork about future inflation rates and tax rates.

The end result is that landlords are discouraged from being short-term flippers and encouraged to be long-term investors.

 

[Texas Proud]

As NORDS have pointed out, there can be some rate issues for some...

But the depreciation is the matching as Red Hawk said... in business, you buy capital assets that have more than a one year benefit. You get to deduct ordinary and necessary business expenses. So, if you buy paper to print on, you get a deduction. The same is for your capital assets, but since the cost is high and the benefits 'long', you only get to deduct the part of the asset you 'used'. So a computer might be 3 years of value to you, so you get to take 1/3 per year. (I am not up on if you get to do double declining etc.. but that is another question)...

For most assets, the actual value of the asset goes down... think computer, car, truck, things like that... but some assets actually go up in value... buildings, houses, etc.

The thinking is that we do not know if the asset will go up or down in value... think of a sport stadium... how many have you seen blown up lately as they had built a new one down the road... there is no value left... so the tax code assumes ALL assets will be worthless in the end... and if they are not, then you should not have received the benefit of the deduction over the years and now should pay the taxes back on those deductions...

We can only know the answer when you sell the asset....

 

[wolf]

OP:

Another consideration. If you do not sell the rental property. Your heirs can inherit the house at market value. (step up in value). And the heirs do not have to "pay back" the depreciation taken on the rental house.

Or you can do a "1031" exchange, "like for like" property and defer the depreciation.

Check with your accountant.

just my 2 cents.

 

[Gone4Good]

how does this save any money?

Time value of money (a dollar today is worth more than a dollar tomorrow). Or as the great economist Wimpy once said "I'd gladly pay you Thursday for a hamburger today."

Also, if you never sell the property, there is no "catch-up".

 

[inquisitive]

OP:

Or you can do a "1031" exchange, "like for like" property and defer the depreciation.

What are the basics of a 1031 exchange? Since I live in the property and rent out rooms, would I have to live in the next property and rent it out also, or would it work if it is a pure rental property?

 

[Meadbh]

Land is not subject to depreciation, because, according to accounting principles, the land is assumed to remain even after the buildings fall down.

I'm not sure how the tax people would deal with the type of situation below.....

 

[Texas Proud]

Land is not subject to depreciation, because, according to accounting principles, the land is assumed to remain even after the buildings fall down.

I'm not sure how the tax people would deal with the type of situation below.....

Is that place being rented to someone Is there insurance


In a general sense... if it were business property and not insurance, the remaining basis would be written off... and the land is still there....

 

[Nords]

What are the basics of a 1031 exchange? Since I live in the property and rent out rooms, would I have to live in the next property and rent it out also, or would it work if it is a pure rental property?

There's a whole industry around putting your money in a 1031 escrow account, doing the purchase of the "equivalent" property, and giving you most of your money back.

1031Exchange.com is a starting point, but you're describing a complification on top of an already complex and time-sensitive transaction. A "pure rental property" seems like a possible result of a 1031 exchange but the challenge would be figuring out the cost basis & depreciation recapture, then assessing the difference between "paying all the fees & expenses of deferring the taxes" versus "just paying the darn taxes and starting over again". (Especially if you can offset your capital gains with other losses.) Then there's the hassle of completing the second closing within the time limits after the first closing.

 

[pb4uski]

Land is not subject to depreciation, because, according to accounting principles, the land is assumed to remain even after the buildings fall down.

I'm not sure how the tax people would deal with the type of situation below.....

Casualty loss I suspect.