Real estate investing has been a popular way for people to build wealth for generations. While there are certainly risks involved, many investors have found that the benefits of real estate investing far outweigh the drawbacks. One of the biggest perks of real estate investing is depreciation. It is a tax advantage that lets real estate owners deduct a percentage of their investment property’s cost each year. In this article, let’s understand why depreciation is the biggest perk of real estate investing and how it can benefit you.
Depreciation is a tax deduction that allows real estate investors to write off the cost of their property over time. The IRS considers real estate to be a depreciating asset, which means that it loses value over time due to wear and tear, deterioration, and obsolescence. Depreciation allows investors to deduct a portion of the cost of their property each year to offset their taxable income.
Depreciation is calculated based on the value of the property, the cost of any improvements made to it, and the useful life of the property. The useful life of a property is the period over which it is expected to generate income. Residential real estate has a useful life of 27.5 years, while commercial real estate has a useful life of 39 years.
Depreciation is one of the most powerful tax benefits available to real estate investors. By reducing taxable income, depreciation helps investors keep more of their rental income and increases their cash flow. For example, if you own a rental property that generates $30,000 in rental income each year and you have $10,000 in deductible expenses, your taxable income is $20,000. However, if you also have $10,000 in depreciation deductions, your taxable income drops to $10,000. This reduces your tax liability and increases your cash flow.
Depreciation also helps investors build wealth over time. As your property depreciates, its value may increase due to market conditions. This means that even as you take depreciation deductions, your property may be appreciating in value, which can increase your equity and net worth.
Real estate bubbles occur when property values rise rapidly due to speculative buying and selling. In a real estate bubble, properties are often overvalued and investors may be tempted to pay more for a property than it is worth. When a bubble bursts, property values may plummet, leaving investors with properties that are worth less than they paid for them.
Rental property depreciation can be a powerful tool for investors during a real estate bubble. While property values may be falling, depreciation deductions can help offset some of the losses. For example, if you purchased a property for $500,000 during a bubble and its value dropped to $400,000, you could still take depreciation deductions on the original purchase price of $500,000. This would help reduce your taxable income and minimize your losses.
Another way that depreciation can benefit real estate investors is through 1031 exchanges. Reinvesting the sale profits into another property through a 1031 exchange enables investors to delay paying taxes on the sale of one property. By exchanging one property for another, investors can continue to take advantage of depreciation deductions and build wealth over time.