Depreciation is one of the most useful tools that you can use to generate wealth out of your real estate investments. Sometimes the value of an investment hides in the details of the paperwork or the accounting records.
So it is with this way to write off the costs of owning and operating a rental property. Depreciation is something that requires expert advice. So before your attempt to understand how depreciation will alter the calculation of your income, make sure that you discuss it with your tax professional.
Depreciation Requires Investment Income
Owning a property to live in and enjoy as a private citizen, is an excellent objective. However, that does not automatically make it an investment. Regardless of how much equity you have, your home is a cost. On the other hand, real estate that brings in rental income is a substantial investment. Deductions do not apply to your residence; they are for properties you own as investments.
You can deduct many of the ownership costs, but depreciation means that you can spread those deductions out over an extended period of years; the process gets more complicated from there.
The concept is that the money that you put into a property stays there as asset value. The amount reduces as if you spend the asset over time. So a new water heater may cost $2,000, but you do not claim that cost up front. Instead, you take the depreciation over five years, writing off $400 each year.
Get Help Before It Gets Technical
There are strict definitions and clearly delineated categories of what you can and cannot depreciate. A major repair might be a capital improvement on which you take depreciation. A lesser expense is unlikely to be sufficient, and you have to take it as a one-time write-off. Also, there is a list of specific expenses that are exempt from writing down as depreciation.
The IRS sanctions an even more elaborate depreciation scheme called the Modified Accelerated Cost Recovery System (MACRS) that uses a formula to apportion depreciation rapidly at first and then at a gradually reducing rate over the full term. Again, you should speak to your certified public accountant before you make any estimates of investment cash flow.
Your Investment Portfolio Cost Reduction Strategy
It is always comforting to generate a profit from your investments, but most investors seek to build long-term equity. When you become the owner of investment properties, your most stressful concern will be making enough income to cover the cost of your investment first, build equity, and then work to earn a profit on top.
Depreciation is one way to increase your chance of producing a positive cash flow from your real estate portfolio; it is an excellent way to make your wealth to work for you. Your real estate broker and CPA are two professionals you will need to start building wealth. Talk to your Realtor and tax advisor to learn how depreciation will make your investment successful.