Rental Property Depreciation Overview

This post will give you a comprehensive overview of how your rental property might be affected by depreciation i.e. rental property depreciation, and how to best prepare for it.

Rental properties get worse over time. A six-month-old apartment might still feel new and shiny from the promise of the future it gave you, but that doesn't mean it's worth is actually higher than an older property which has had its value reduced through depreciation.

Depreciation is the name given to the decrease in value of a property over time, usually because it was not properly maintained or managed and/or there were outside factors that hindered what would have been normal results (like natural disasters or economic downturns).

All types of tax-paying entities, including individuals, corporations, partnerships and limited liability companies (LLCs), can depreciate a property over certain periods of time. The amount you can depreciate from a property depends on the type of entity you are and the type of property you own.

Essentially depreciation is used to pay for the replacement cost of your rental over several years. This means that if you've spent $150,000 on building repairs over the last few years, but your rental is currently only worth $100,000 (due to depreciation), you don't have to pay taxes on more than $100,000 when it's time to sell or transfer ownership.

So, what does depreciation look like?

Let's say that you just bought a five-year-old apartment building. For simplicity sake, let's say you paid $200,000 for it. As property ages and is depreciated over time, the cost of the building itself should decrease (so if you're in a commercial area and you renovated one year ago, it might be worth $150,000 now). Inversely, maintenance and other expenses associated with running the property should also decrease over time. Let's say this apartment is your primary rental property which you use to occupy most of your time.

Property depreciation is an effective way to reduce taxes on rental property owners' income. As the IRS explains, "You deduct a loss from the rental real estate activity on Schedule A (Form 1040), subject to limitations, as a miscellaneous itemized deduction."

As if calculating your rental property's depreciation isn't difficult enough, you also have to factor in what type of depreciation you use and how long it takes. There are two types of depreciation: straight-line depreciation which typically depreciates buildings over 27.5 years (residential buildings) and 39 years (non-residential buildings), and accelerated depreciation which allows you to depreciate your building over different periods of time, usually 15 or 19 years.

There are three types of accelerated depreciation: the percentage-of-cost method, a multiple-of-cost method, and an unusable life method. The terminology can be a bit confusing but understanding the differences is important.

For example, let's say you bought your property for $200,000 and will depreciate it for 39 years. You would then deduct $81,750 each year over the first 10 years of ownership ($39k x 10) as well as $844 per year in maintenance costs over the last three years ($39k x 3). It looks like this:

As you can see, this is quite complicated to compute and there are several different ways to go about it. I recommend using a depreciation calculator like Depreciation Works which estimates your total depreciable basis (the cost of your property minus any improvements made after purchase) and then tells you what you can deduct on a monthly basis.gs with new additions or smaller square footage. If the property was 10,000 sq ft or larger with more than 40 years of life left, you would have continued to deduct $632 per year until the 39th year.)

However, be warned that depreciation calculators are not 100% accurate so they're best used as guides rather than final values.

Let's say that six years after you bought the property, you took down half of the ceilings in your vacant apartments to upgrade them ($50k). You can actually deduct this amount over three years from those costs, as well as any other expenses related to those renovations. In this example, let's say that total costs are $80,000.

As you can see above, we first deducted depreciation cost ($81K), then subtracted the cost of taking down ceilings ($50k) and then deducted those costs again on top of where we left off with $80k. We've now deducted $91k rather than $81k.

So, what does all this mean for you? Well, depending on the type of property you own and how much time has passed since purchase, depreciation might take more or less than 39 years to fully figure out. For example, if your building only took one year to build then it's likely that your rental is within the first year of being depreciated. Because of this fact, don't expect the difference in taxes between a new and used property to be huge. On the other hand, if you purchased an old building with many years under its belt then it's likely that your rental property is still within a few years of being depreciated.

What it all boils down to is that rental property depreciation isn't always a good thing. You're essentially writing off a large portion of your money spent on the property over time to save on taxes (though it's also why depreciation is considered a "miscellaneous itemized deduction" and not an actual line-item on Form 1040).

Moreover, if you do get audited by the IRS, they'll likely ask to see your depreciation schedule, as well as create an arm's length sale or two in order to compare your calculations with those of a business owner who has sold similar properties. If you don't have any documentation or have made mistakes then you can expect trouble down the road.

Depreciation is one of the most important and time-consuming aspects of being a rental property owner. However, it's also one of the most confusing and overwhelming parts of the equation. If you want to know more about depreciation and how it works, here is an excellent guide from IRS Publication 946.

What's The Difference Between Net Operating Income (NOI) And Gross Revenue?

Net Operating Income (NOI) is a measure of the income generated by a company's assets minus the expenses to run those assets. Gross Revenue, on the other hand, refers to all money flowing into and out of a company. For example, if your business has $10 million in gross revenue but $5 million in NOI, then you are earning 5 cents per dollar of GROSS REVENUE.

The difference between NOI and GROSS REVENUE is that NOI includes earnings from all forms of assets: both tangible (such as land or buildings) and intangible (such as goodwill). On the contrary, gross revenue only includes cash sales or receipts for products sold by a company. An additional example is the total payroll expenditures of a company; NOI includes it, while GROSS REVENUE doesn't.

While Gross Revenue is used to measure a company's cash flow, NOI is sometimes used by lenders and investors as an indication of how much money the company will make in the future. Investors and lenders are concerned about how much money the company can generate after paying expenses such as property taxes or operating costs. Such calculations are important, since they determine how much debt a company can incur and what rate of return investors should expect to receive on their investment.

Gross revenue is also known as gross income.

NOI, or Net Operating Income, is the money left over after all operating expenses are subtracted from gross revenue. If you would like to know how to calculate NOI then check out my guide discussing operating income for landlords here.

While NOI is a more realistic metric, gross revenue is the easiest to calculate and is often reported in marketing materials by many real estate investors. You could also get an idea of potential rent prices and other costs by looking at the building's gross revenue.

The result of NOI minus operating expenses should equal your bottom line profit. As you can imagine, this figure is much more important than gross revenue itself. If you have a great relationship with your property manager and/or are able to keep all operating expenses low then it's likely that the positive figures will outweigh the negatives.

For more information, you can visit Real Estate Calculators.