Author Topic: Newbie question about depreciation  (Read 1206 times)

AMandM

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Newbie question about depreciation
« on: September 01, 2018, 08:52:50 PM »
DH and I are toying with the idea of buying a rental house.  I have some questions about depreciation with respect to income taxes.

As I understand it, we declare the rent as income.  We deduct the interest on the mortgage, the real estate taxes, the insurance, the cost of repairs, etc.  We also deduct an amount for depreciation. The income that is left after deductions is taxed.

If and when we sell the property, we pay capital gains not only on the difference between the selling price and our purchase price, but also on the depreciation amount.

So I guess my first question is, am I correct?
Because my second question is, what's the logic behind depreciation?  I understand deducting the costs of maintenance, because that's expenses that are necessary to keep the house rentable. But since they keep the house rentable, it's not depreciating, right?  I mean, it's not becoming any less capable of generating income.  All I can think of is that it makes me pay capital gains tax instead of regular income tax on the purchase price of the house.  What am I missing?

Thank you!





Papa bear

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Re: Newbie question about depreciation
« Reply #1 on: September 01, 2018, 09:12:02 PM »
1) yes, you pay capital gains taxes on sale price less your cost basis (purchase price plus capital expenditures less depreciation)

2) depreciation/amortization is the way you get to expense a business asset.  This is done over time and not the year it is placed in service.

For example, business buys a bunch of furniture. It costs 50k. They don't expense 50k, the furniture is an asset that will be expensed over time, based on IRS guidelines such as MACRS.

In real estate, let's say you remodel a kitchen, or replace a furnace.  Those typically aren't expensed, they are capitalized over a period.  So they are an asset that slowly depreciates. 

The IRS says your rental property is a business asset that gets depreciated. 

(It's been a long time since I did tax accounting, so I may not be 100% on all this anymore!)


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AMandM

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Re: Newbie question about depreciation
« Reply #2 on: September 01, 2018, 10:27:58 PM »
I get depreciation for assets that wear out. I buy equipment for my business. After a while the furniture or truck or camera can't be used any more in the business, and I have to replace it so I can keep my business going.

But if I buy a rental house, it doesn't wear out or go away.  I can keep renting it out indefinitely. Why do I have to depreciate a house?

Papa bear

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Re: Newbie question about depreciation
« Reply #3 on: September 02, 2018, 06:10:18 AM »
A house does wear out!  If you make no capital expenditures for 27.5 years, it's economic value is pretty damn low.  I doubt you could continue to rent it.

Other major business assets require maintenance.  But with regular upkeep or improvements, their useful life will far exceed its depreciable life. A house is the same way.

Compare a house, say, to a tanker ship.  I don't think you would argue that the ship shouldn't be depreciated. It's clearly a business asset. And it should have a very long serviceable life.  But it will require regular maintenance and improvements to keep it up to date and profitable. 


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ilsy

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Re: Newbie question about depreciation
« Reply #4 on: September 02, 2018, 10:02:25 AM »
I get depreciation for assets that wear out. I buy equipment for my business. After a while the furniture or truck or camera can't be used any more in the business, and I have to replace it so I can keep my business going.

But if I buy a rental house, it doesn't wear out or go away.  I can keep renting it out indefinitely. Why do I have to depreciate a house?
A house consists of items that wear out, like a water heater (life expectancy is about 10years), roof (15-30 years), plumbing, electrical. Only the land doesn't depreciate because it doesn't deteriorate over time.

Imagine a house that is a 100 years old, if no capital expenditures were made the electrical and plumbing are not built to accommodate a dryer (a standard in every rental now), no AC, the garage door opens manually, no showers (bath only), electrical in the kitchen can't accommodate large fridges, toaster, microwave (standard in rentals). Bottom line, even if the house was maintained somehow, and the roof is on (which is maintenance and doesn't increase the value of a house), the rent you are able to collect is pretty modest, might cover taxes and insurance, but not the roof replacement, AC or furnace, or even a serious plumbing problem, which will come up in a 100 year old house. Those houses are going to dilapidate beyond a patch up job and become abandoned.

And that's why every now and then (30 years or so) a house has to have major capital expenditures to bring it up to a current value of similar newer houses.

AMandM

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Re: Newbie question about depreciation
« Reply #5 on: September 02, 2018, 11:58:27 AM »
It still feels like double-dipping to me. Here's why:
Suppose I have a $200k house. To keep its value at $200k, I spend $1000/yr on repairs and maintenance, which I expense, and an average of $1000/yr on capital expenditures, which get depreciated.  If I also depreciate the $200k purchase price of the house, then after 27.5 years I have, on paper, zero assets when in fact I still have an asset worth $200k.

Papa bear

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Re: Newbie question about depreciation
« Reply #6 on: September 02, 2018, 02:25:02 PM »
It's not double dipping. It's a tax deferral in your case. There aren't many ways to bypass this, but it's possible.

You will pay taxes on your gain. Sale price less cost basis. If your cost basis is 0, you have the entire sales price as gain.

Say your business bought wood desks for the entire office.  They depreciate over 10 years per the MACRS tables. Well, the wood desk still has actual market value after 10 years.  If you sell the desk, you pay taxes on the gain.  So you don't double dip, you just deferred the tax payment.


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AMandM

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Re: Newbie question about depreciation
« Reply #7 on: September 03, 2018, 08:42:55 AM »
It's not double dipping. It's a tax deferral in your case.

Ah, I see now. Thank you!

Fishingmn

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Re: Newbie question about depreciation
« Reply #8 on: September 03, 2018, 07:42:50 PM »
It still feels like double-dipping to me. Here's why:
Suppose I have a $200k house. To keep its value at $200k, I spend $1000/yr on repairs and maintenance, which I expense, and an average of $1000/yr on capital expenditures, which get depreciated.  If I also depreciate the $200k purchase price of the house, then after 27.5 years I have, on paper, zero assets when in fact I still have an asset worth $200k.

Keep in mind that you need to separate the structure from the land. You don't depreciate the land since that is considered to hold its value so the asset will never go to zero.

Normally, I look at the tax assessed value which breaks out land/building to figure out the ratio to apply based on the purchase price.

AMandM

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Re: Newbie question about depreciation
« Reply #9 on: September 04, 2018, 08:56:18 AM »
Yes, thanks, Fishingmn. I didn't make that distinction in my example.

jc4

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Re: Newbie question about depreciation
« Reply #10 on: September 06, 2018, 06:37:48 AM »
It's common (not guarenteed) with rental property (esp. older ones) to do minimum maintenence to keep the property habitable, but not up to date / good shape. The home gradually deteriorates to worthless, and is renovated / torn down. Having seen enough rentals run into the ground, I see the rational in depreciating property. 

On the other hand if you do enough maintenence that by some good fortune you end up with a valuable asset at the end, then the IRS says "oh", we should have taxed you, we'll take that now".

TLDR: The IRS assumes you're losing some economic value on the deterioration of the home. If at the end the assumption proves untrue, they then true up at that point.

brian.ellwood

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Re: Newbie question about depreciation
« Reply #11 on: September 13, 2018, 11:09:14 AM »
You deduct 1/27th of the value of the structure (not the land) per year, for 27 years. So if the structure is worth 50K, the depreciation write-off is $1,851 per year, which is significant!

wbranch

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Re: Newbie question about depreciation
« Reply #12 on: September 13, 2018, 01:12:56 PM »
Another way to think of it is that tax depreciation is the allocation of an expense over a time and method set by the IRS.

Do not think of it of as having anything to do with economic depreciation or decrease in value.

Curmudgeon

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Re: Newbie question about depreciation
« Reply #13 on: September 13, 2018, 02:11:47 PM »
Don't forget too, that the tax rate you pay on the depreciation (when you sell the house) is 25%, regardless of what tax rate you were paying when you claimed the depreciation.
This is one of the things that makes me question the value of buying real estate.  I plan to be in the 12-15% bracket for the forseeable future, so buying a 200K house and holding for 27.5 years means I pay a tax penalty of (25%-15%)*200K = 20K when I sell.

tralfamadorian

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Re: Newbie question about depreciation
« Reply #14 on: September 13, 2018, 06:54:29 PM »
Don't forget too, that the tax rate you pay on the depreciation (when you sell the house) is 25%, regardless of what tax rate you were paying when you claimed the depreciation.
This is one of the things that makes me question the value of buying real estate.  I plan to be in the 12-15% bracket for the forseeable future, so buying a 200K house and holding for 27.5 years means I pay a tax penalty of (25%-15%)*200K = 20K when I sell.

This is very, very common misunderstanding. Depreciation recapture is taxed at your nominal income tax rate up to a maximum of 25%.

Curmudgeon

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Re: Newbie question about depreciation
« Reply #15 on: September 13, 2018, 10:13:20 PM »
Don't forget too, that the tax rate you pay on the depreciation (when you sell the house) is 25%

This is very, very common misunderstanding. Depreciation recapture is taxed at your nominal income tax rate up to a maximum of 25%.

Thanks for correcting me! Definitely not an expert on this, and I've never seen it explained this way.  But with further research, I see you're correct.

However, for my situation, it seems as though it may be a moot point:  Assuming I'm near the top of a lower tax bracket (in my case, 12%)  the depreciation is going to be a deduction for the 12% bracket, and then the recapture - which is all realized in one year - is all going to get taxed at higher brackets.  Still not good, but not nearly as bad as I thought.