What the heck is depreciation, and how does it work?
Dan is going to answer exactly that in this bonus episode! We all know that real estate is a great investment vehicle. You’ve heard us say it a bunch on our podcast. It’s a hedge against inflation. It’s a cash flow producing asset. The depreciation and specifically the tax benefits of real estate are one of the reasons that a lot of people love it.
So what exactly is it?!
Find out on this week’s bonus episode of Multifamily Investing Made Simple!
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“The depreciation and specifically the tax benefits of real estate are one of the reasons that a lot of people love it.” – Dan Krueger
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What Is Depreciation
[00:00:00] Dan: What the heck is depreciation and why does it matter? That’s what we’re gonna go over today.
And today I’m going to demystify depreciation, or at least I’m gonna try to, so we all know that real estate is a great investment vehicle. You’ve heard us say it a bunch on our podcast. We’ve probably heard it all over the place. Um, and there’s a lot of reasons why it’s great. It’s hedge against inflation.
It’s a cash flow producing asset. Um, supply and demand is very much in favor of, uh, of this as a good investment right now. Uh, but the depreciation and specifically the tax benefits of real estate are one of the reasons that, uh, a lot of people love it, specifically. Those really high income people who are looking to find tax efficient vehicles and depreciation is really the ticket to why it’s a tax efficient vehicle.
So we’re gonna break that down for you. [00:01:00] Depreciation is effectively just, uh, a Phantom expense is what we’ll call it. It’s, uh, almost like a credit that you get on your taxes for the theoretical wear and tear, uh, that the building that you own is, is going through. So we all know that these buildings that we’re investing in are appreciating over time.
But for tax purposes, you get to take, uh, I’m gonna call a credit, uh, for the theoretical depreciation of the asset. Now this is very counterintuitive for people because on one hand, your building is increasing and in value, uh, as inflation takes place and as the, the building gets repositioned and fixed up, assuming that it’s a, a value add deal, it’s counterintuitive to think of the building actually losing value at the same time.
As far as your taxes are concerned, it is. So what we do in, uh, in for most people, what they would do is they would take that value of the building and depreciate in, in a straight line method over 27 and a half years. Now, [00:02:00] why is a 27 and a half years? I don’t know the IRS just pick that number, but for multifamily properties, the traditional straight line depreciation method, as you take the value of the building, not the land and you divide.
Over 27 and a half years. So every year you get to take 1 27 and a half of the value of the building and deduct that from your taxable income. So let’s just say, um, you have a hundred thousand dollars building and that 1 27 and a half, uh, portion of that depreciation in the first year, let’s just say $10,000.
So let’s say in this first year you got $5,000 in distributions from your property and your depreciation. Given the straight line method is $10,000. That means you got $5,000 in distributions, but you’ve got this $10,000 quote unquote loss, and you only have to pay taxes on what’s left over. So your $5,000 of income is washed out by that $10,000 of losses.
And the remaining losses go carry forward to the [00:03:00] next year until you, em. Now with multi-family properties and pretty much any commercial property, you can actually accelerate that depreciation substantially. And that’s what we do on all of our properties. We do this through something called a cost segregation study.
And what that does is it allocates all the different components of the building. Into their appropriate, useful life buckets. And you have an engineer come in and you perform this study. And what you do is you say, okay, the windows are not gonna last 27 and a half years. And the carpet’s not gonna last 27 and a half years.
And the appliances aren’t gonna last 27 and a half years. So on and so forth. You break everything down in that building into its appropriate, useful life bucket. It could be one years, five years, seven years, 10 years, 15 or 27 and a half years. And what you find is almost everything is gonna fall in. The non 27 half year buckets, typically the roof and some of those larger components are gonna actually that actually last 27 and a half years, but everything else is gonna be in an earlier bucket.
So you get to accelerate that depreciation schedule from a straight line method where [00:04:00] everything goes over 27, 27 and a half years, uh, to a method that’s a little bit more accurate. and you can take it a step farther with the tax rules that came into place in, uh, 2016. Anything that’s not in that 27 and a half year bucket, you can actually take in year one.
So on the properties where we’ve executed our, um, uh, cost aggregation study and, uh, delivered these K one store. Our, our investors we’ve seen anywhere from about 45 to 65% of someone’s initial investment showing up as a loss on the first, uh, K one that they. So, if you would invest in a hundred thousand dollars in a building, we performed a cost aggregation study.
Uh, it’s not uncommon to see 50 or even $60,000 of losses showing up in that first year, uh, on your K one. And so for our deals, we usually see anywhere from five, six, 7% returns in that first year. Somebody who invested a hundred thousand dollars might see six or $7,000 of distributions in that first year.
And then they get to see a nice big fat [00:05:00] 50 or $60,000 loss, which means that the tax liability on that first year is gonna get dropped down to. Nothing and those unused losses get to carry forward to the next year. So what we end up seeing is, uh, the first several years of a real estate syndication, having little to no tax liability for investors.
Now there’s gonna be some on the back end, but what I’ve found in doing the math on, on most of our deals is that the actual effective tax rate for most people is gonna be maybe 10 or 15%. Now, not a CPA. This is not financial advice or, or tax advice or anything like that. This is just trying to illustrate a concept for you that.
Net net the tax liability on dollars you make in a real estate syndication is gonna be far less than almost anything else you could be investing in. So it ends up being a. Tax efficient investment. So I hope this, I hope this helps demystify the depreciation and tax benefits of, of real estate. If you guys have any other questions about this, feel free to reach out to us and check out all the content they’re reporting out, uh, on these types of topics.
We’ll see you guys in the next video.[00:06:00]