How does depreciation work?

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One of the benefits property investors often talk about is the power of depreciation. But what exactly is depreciation and how does it work?

If you make a profit in business, you have to pay taxes on that profit. However, the less you earn, the less you need to pay in taxes. Makes sense right?

To calculate how much you owe in taxes, you need to first calculate your profits.

So a simple calculation for figuring out your profit might be:

REVENUE (money your earned) less EXPENSES (money you spent)

When you own a cashflowing property, the rent you collect is considered revenue. To calculate how much you owe in taxes, you need to know how much profit you made, so you need to consider your expenses.

Let's say you earned $1,000 / month in rent. So in one year, you earned $12,000.

But you also had some expenses. You spent $100 a month on property management for a total of $1,200 / year. You also spent $600 in repairs for the year.

Now you calculate your profit (I'm assuming you're not paying debt on this property and that you own this free and clear without a loan from the bank).

$12,000 - ($1,200 + $600)

$12,000 - $1,800

Profit: $10,200

(Note: This is a very simple example and shouldn't be viewed as typical.)

Here's where depreciation comes into play. You can further reduce your "profit" by adding in a depreciation expense.

What is Depreciation?

When you buy a piece of property, the IRS assumes that you will eventually "have to replace" the property. In other words, it won't last forever.

So you are allowed to deduct the "cost" of replacing the property from your profits.

Imagine your property cost you $100,000. Then, simply put, because one day you'll have to replace that property, you can deduct $100,000 from your profits.

But there are a couple of points to first consider.

First, you don't get to deduct the entire $100,000. Instead, your county assessor or appraiser has valued your house by dividing the cost of the house structure itself (also known as the "Improvements") and the cost of the land. Typically, a county assessor will assign 75% of the price you paid for your house to the improvements and 25% to the land itself.

The IRS will only allow you to deduct the cost of the improvements. So in this example, you'd deduct:

$100,000 x 75% = $75,000

You can deduct $75,000 from your tax bill (75% is not based on the picture below).

(Consult a tax professional to find out how to divide the value of your improvements vs the land. You can also look at the county assessor's website and search for your property to find out this information. It will look something like what you see below.)

How do you calculate depreciation on your rental property?
How do you calculate depreciation on your rental property?

Second, you don't get to deduct that amount all at once. Instead, you have to divide that $75,000 by 27.5 years. Why? Because the IRS values all residential properties as having a useful life of 27.5 years. (In reality, most houses will last much longer than this. But this is the number that is used. For a Commercial Property, the number of years is 39 years.)

$75,000 / 27.5 = $2,727

Third, to calculate your tax savings, now multiply that number by the % you pay in taxes (according to your tax bracket). If your tax bracket is 35%, then your savings would be:

$2,727 x 35% = $954

Where does that savings come from? Since you get to deduct $2,727 from your profits:

$10,200 - $2,727 = $7,473

You've reduced the amount of taxes you need to pay. Think of it this way. Without depreciation, you would have paid the following in taxes:

$10,200 x 35% = $3,570

With depreciation, you pay the following:

$7,473 x 35% = $2,615

Your saving:

$3,570 - $2,615 = $955

(It's off by $1 from the above calculation because of rounding.)

Of course, it's not all rosy.. When you sell your property, you will have to repay the deductions that you took! However, that's a discussion to save for another day.

Remember - this is just an example. Please consult a tax professional for more specific details. (Also, there are other deductions a person might take, as well as other expenses that may incur.)

Also, be sure to RSVP now for the Seoul Real Estate's next meetup, on October 17, 2015, in Gangnam.

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