Rental property depreciation - a big tax write off for a big return
For this article I had initially planned on writing about the tax benefits of owning a rental property. Then I got to thinking that a 15,000+ word document would not be suitable for attracting and keeping viewers. Ideally I should structure these articles in an iterative fashion, with numerous building blocks, leading up to a final summary page on this site. There are a few reasons for this:
Long posts are boring.
I don’t know anybody who will sit through a huge article and retain all the talking points with clarity.
Google searches are oft limited to small questions like “how much is the depreciation of a washing machine?” etc… and if you search a specific topic, you will most likely be directed to a specific to-the-point type article
I would like to update once a week nominally, not once every 2 months.
With all that in mind, I mentally pruned a massive task down to this one. A small building block in the financial world called rental property depreciation. Everybody has heard the term but unless you have gone through the exercise of renting out a property that you own, you probably can’t put a face to the handsome stranger called “Depreciation.”
(PIC of handsome depreciation stranger)
The basic calculation for straight line 27.5 year depreciation is as follows:
(Value of Home$)/(27.5years) = Depreciation in $/yr
Where the Value of Home is the value of the entire property minus the value of the land. This is shown most frequently on your taxes and appraisals as Land and Improvements. The value of the improvements is the value of the home and everything else built on the property.
This means that for every year (up to and including 27.5 years) you own your home you can write off the depreciation calculated above in $/yr. If you write off something it basically means it is a deduction. Deductions save you taxes. The amount of taxes saved on a deduction are based on your tax bracket, which is based on your net earnings for the year. A low tax bracket for a middle class family would be ~14% whereas a high tax bracket could be upwards of 30% if you have no deductions or write offs. How unfair is this for the middle class? Anyway back to the point your savings are directly related to your tax bracket and your depreciation write off. I have made a chart here to illustrate the value of the linear depreciation based upon rental property purchase value:
I made the assumption that land is going to be 15% of your property value. Some places like large expensive cities will see this figure be much higher, whereas in rural areas it will be lower. To calculate this number for tax purposes, simply use the land/improvements values on your appraisal as they will certainly suffice.
The values on the right side of the graph equate to CASH IN YOUR POCKET at tax time. But wait, not all is equal here in the land of the free, and this graph shows it. If someone makes more money per year, they can save more money with a rental property than a person who makes less! This is fascinating and we can use it to our full advantage if we think about it a minute. Generally a person will not make too much money while in high school or in college. They will make increasing amounts of money per year until they retire, at which point their income will again drop. So it would not make sense to leverage a depreciation write off during education years or during retirement years. It would make the most financial sense to have a depreciating rental property during your career/working years, especially if you are near the 30% bracket without your itemized deductions.
Depreciation Recapture Tax:
I should mention here that the depreciation value of a home is not exactly free money. You must claim the depreciated value when you sell the home. For instance, if you sell the home in 3 years for the same price you bought it for, you would owe (3years) x (depreciation$/year) x (25% depreciation recapture) to the IRS. This 25% is a fixed rate and it doesn’t matter your income bracket. If the only benefit of owning a rental property was the depreciation write off, you would have to have a higher tax bracket than 25% when you were saving money during the rental period for this to make any sense at all. The government knows this which is why they set the rate so high for this deduction. This is also assuming that you would do nothing with the money you saved and it earned 0% interest after you saved it, which is a bad assumption. Your personal investments should not stagnate while you leverage the savings from your rental, they will most likely grow with the markets at a minimum. Let’s say you had a 500,000$ house you rented out in the SF bay area of california, that would mean you save 4,636$ a year (386$/month) in the 30% tax bracket, which in turn means you can invest that money into a yielding account with an extremely conservative 70% stocks allocation on Betterment, and still make a killing when you sell it!
The amount you have invested after 26 years would be ~120,000$, but the returns will be nominally quite high as seen above. Compounding interest is the best thing since sliced bread, but it takes longer to get.
But wait, there is even more good news! Luckily for us, there are many more benefits to owning a rental property than just the depreciation deductions. There is also the rental income, interest deduction, property value increase, property tax deduction, and inflation. I should be able to write up a good summary for you all in time, one building block after the other. Stay tuned fans!