Let’s start with a warning:  I am neither an accountant nor a tax attorney.  More importantly, I am not your accountant or tax attorney.  What follows is simply my layman’s understanding of a particularly obscure part of the tax code.  Before you try any of the below, be sure to consult with the appropriate professional.

‘Nuff said.

[This article is part one of a three four five-part article on a nifty little tax product I've dreamed up.  Part 1 gives an introduction, part 2 will get more advanced, and part 3 is where I'll unveil what I have in mind.  Parts one through four are an introduction.  I'll be particularly curious about what Jeff Brown, the godfather of real estate investment blogging, will have to say about it.]

As part of Uncle Sam’s never-ending tax-law-driven social-engineering crusade to promote certain societal goods — in this case investing in real estate — there are some interesting tax laws on the book having to do with depreciation of real estate investment properties.  Roughly speaking, here’s how it works.

1. You buy an investment property for, say, $500,000.  (Momentary pause to let my Bay Area readers recover from a laughing fit.)  Let’s imagine $225,000 of that is the value of the land itself; the remaining $275,000 – the value of the home itself — is, from the point of view of the IRS, a depreciable asset.  That’s right, depreciable asset — even though, over time, real estate tends to appreciate, not depreciate.  (Keep in mind we’re dealing with tax laws.  They don’t necessarily have a relationship to reality.)
2. From a tax point of view, you’re allowed to depreciate that $275,000 over 27.5 years using straight-line depreciation, which comes out to an even $10,000 per year.  (I picked the above numbers carefully.)  If you’re in, say, the 30% marginal tax bracket, that comes out to a nifty little $3000 in tax savings per year.

To give a very simple example, let’s imagine that you’re taxed 30% on every dollar you earn, and that you have no other deductions, and let’s say you earn $80,000 per year.  Your tax bill would normally be $80,000 X 30% = $24,000.  But because of your investment property, which is spitting out $10,000 per year in depreciation, Uncle Sam is only going to tax you on $80,000 less $10,000 — ie. on $70,000.  30% of that is only $21,000.  Voila!  You just saved $3000 in taxes.

What’s great about depreciation from a tax point of view is that it’s a non-cash expense, a phantom expense, if you will, and yet Uncle Sam treats it as if you had genuinely spent $10,000 out of your own pocket in order to qualify for that $3000 in tax savings.

Let’s do an even more specific example.  Let’s say that your investment property brings in $30,000 per year in rent.  (Another momentary pause for my Bay Area readers.  Yes, there are places in this country that give a 6% return.  Heck, there are probably places that give a 10% return.)  Let’s say that you incurred $25,000 in expenses, netting you a cool $5,000 profit for that year on your investment property.  That’s $5,000 of cold, hard cash you can put in your pocket.

Yes, you have to report that income to Uncle Sam, bringing your total to $85,000, with a resulting tax bill of $25,500.  But your $10,000 depreciation means Uncle Sam only taxes you on $75,000, and you only have to pay $22,500.  Again, a $3000 savings.

For more reading on this, Jeff Brown has an excellent repository of articles on real estate depreciation.

Tags: Industry, Investing
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• Financial Alchemy: Depreciation, Passive Losses, Real Estate Professionals, And Uncle Sam (Part 2 — Further Introduction)
• Financial Alchemy: Depreciation, Passive Losses, Real Estate Professionals, And Uncle Sam (Part 3 — Yet More Introduction)