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You wrote, But my question is, unless the property is losing value, how can it be depreciated?

I understand depreciating certain assets in a business, like a computer or delivery truck, but those are items that lose value over time, while real estate typically gains value provided the neighborhood is in a good area.

I guess you could say it's a numbers game. One designed to potentially defer your income taxes into the future.

In accounting, you rarely consider the present market value of an asset. All tangible, man-made assets tend to decline in value over time. This is the argument for depreciating a structure. However, raw materials like land don't really depreciate; but they do go up and down in value depending on demand.

A property that appreciates generally does so because the demand for the (location of the) land has increased -- not because of the value of the structure. Usually the structure has declined in value, though that may not always be so if inflation is out pacing the structure's rate of decline.

As a practical matter, in your bookkeeping records you would declare the value of a structure and the property it sits on separately. Then you would estimate a final salvage value and time-frame for the structure. Then you would choose a depreciation method that models the loss in value of the property as accurately as possible. For instance, a vehicle declines in value rapidly at first, so an accelerated method may be appropriate. Structures tend to deteriorate a little more linearly.

Before income tax reform in 1986, the IRS allowed a property owner to declare the property's value, term and depreciation method. The IRS accepted any of a number of depreciation methods. They also allowed you to choose a term that you considered appropriate given the structure -- not all structures are created equal. In 1986 the U. S. Legislature put a stop to this practice because it was easily abused -- allowing wealthy individuals to shelter their income by buying up rental properties and deferring taxes until the properties had to be sold. (In fact, at various times in our history, the legislature has suspended the capital gains tax so someone sheltering their income in this fashion could theoretically avoid income taxes completely.)

As far as I know, single-family dwellings must now be depreciated over 27.5 years using a simple straight-line (linear) method. To figure the depreciation allowance in any full year, you take the original cost basis and divide by 27.5. Major improvements or additions to a structure complicate the matter because you have to roll this cost back into your cost basis and figure a new term.

The catch is that IRS rules still don't require you to separate the cost of the structure from the cost of the land. So if you live in an area where land values are high, you may be able to bury some your income in rental property because you can deduct the on-paper depreciation from your income and then when you sell it, you only pay taxes at capital gains tax rates. What's more, you don't have to pay taxes on the income until you actually sell the property. Of course, the IRS has a cap on how much of a net loss you can write off of your income to limit these abuses as well -- something we'll all squeal about next April when we want to write off some of our stock losses.

In general though, rental properties are a pain in the *ss -- and I say this from experience. I decided several years ago that unless I was willing to jump into it full time, that the difficulties and irregularity in expenses would never allow it to pay off for me. After 1986, a new property owner has only a minimal tax advantage from owning the property. Also, margins tend to be thin and the risks are significant.

Anyway, I know I rambled a bit; but I hope that explaination helps.

- Joel
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