How Does Depreciation Work?

Depreciation

Posted By: Pat Nelson / Jun 26 2017

One of the biggest advantages to investing in real estate are the tax benefits. Because the IRS allows the cost of income-producing property to be recovered through yearly tax deductions, in many cases it’s entirely possible to create a monthly cash flow without paying any tax on it.

How is this possible? A big part of the equation is depreciation, a non-cash – or paper – deduction that allows you to spread out the cost of buying a property over decades.

“Real estate is one of the only assets where you can depreciate or write off some of the wear and tear and usage of the property and shelter some of the income while still having the benefit of appreciation over time,” said Brian Nelson, principal at Nelson Brothers Professional Real Estate.

In his “Ask the Brothers” video series, Nelson explains the three main factors that play into depreciation: the classification schedule set up by the IRS, the ratio of the land value to property value, and your leverage in the property.

Depreciation schedules

The IRS assigns different depreciation schedules to different assets. A retail or office building, for example, is said to depreciate over 39 years, while a residential rental property is depreciated over 27.5 years.

“With student housing properties, the IRS gives a very favorable depreciation schedule so that a lot of folks who own triple-net leases or retail properties or office properties, they’re not used to having such strong depreciation,” Nelson said. “Typically, those will shelter 40 percent to 50 percent of the income. For student housing, the depreciation schedule alone allows you to shield 60 percent to 70 percent of the income.”

Land value vs. building value

You can depreciate only the cost of the land, not the cost of the building. “So whenever you buy a property,” Nelson says, “you have to figure out how much of the value of the investment is attributed to the land and how much is attributed to the building.”

Part of Nelson Brothers’ strategy is to seek out properties in smaller metro areas like Eugene, Ore., or Provo, Utah, or South Bend, Ind.

“In these tertiary markets, the land value is minimal,” Nelson explains. “So if you’re buying a property in South Bend, Indiana, for example, typically 90 percent to 95 percent of your investment is depreciable. It’s in the building itself; whereas a lot of folks who own property in California or New York, 40 percent to 50 percent of their investment might be tied to the land as it’s not depreciable.”

Leverage

The third element is leverage, which refers to the ratio of debt to equity.

“By having a little bit higher leverage, it means that you’re buying a little more of the building, which we can then depreciate and shelter more income from,” Nelson says.

Nelson Brothers typically takes out a loan that is roughly 50 percent to 60 percent of the property’s value, which protects investors from liability while providing the benefits of ownership.

Nelson Brothers also has its own in-house tax accountant. Investors will receive a K-1 or a 1099 every February or March, depending on how their properties are structured, that calculates the depreciation for you.

The bottom line

“These three things taken in total are what makes Nelson Brothers so strong on tax shelter. Where else can you find an investment where you can have a 6½ to 7 percent income and in many cases not pay a dime of that to Uncle Sam? It’s 100 percent tax sheltered. We think it’s phenomenal and really unique to our business model.”