Real Estate Depreciation is a key element of Real Estate Investing, and inflation can be a real killer, so today we are talking about:
- the real value of dollars, at different points in time,
- the amount of Real Estate Depreciation that you can actually deduct, and
- how that Depreciation compares to how much you were promised that you could deduct.
I’ll show you four things:
- Why the value of the dollar changes every year,
- How to predict those changes in dollar value,
- How those changes in dollar value will reduce the actual benefits of your Depreciation, by about 25%, and
- One situation where you can receive immediate 100% dollar value of the Depreciation each year.
So, let’s get started.
REAL ESTATE DEPRECIATION
I love Depreciation.
I really do.
In over 50 years of real estate investing, I estimate that 10-30% of my profit was due to understanding how to use Depreciation. And I have never had a Depreciation Schedule challenged by the IRS.
The biggest value of Depreciation is in the early years of any investment, because that’s where you see most of the benefit from Depreciation.
And that’s because of the time value of money, the difference between what a dollar in your hand is worth today, and the Present Value of a dollar that you will receive in the future.
If you are holding your money in cash, the buying power of the money, which is its value, will decrease each year by the amount of inflation that is in the economy that year, called the Inflation Rate.
If you need a refresher on Depreciation, I wrote a recent Blog Post called Lease-Purchase For The Seller which will show how it works.
THE INFLATION RATE
Let’s look at what the Inflation Rate is, using the formula of the Government.
The St. Louis Federal Reserve keeps tract of the inflation rate.
The Inflation Rate is calculated using the changes in the Consumer Price Index (CPI) for two years running.
The CPI is tracked by the Bureau of Labor Statistics.
For example, to calculate the Inflation Rate for the month of January 2017 you subtract the January 2016 CPI of 236.916 from the January 2017 CPI of 242.839.
The result is 5.923. It increased that much. That’s an absolute number.
Then you divide this number by the January 2016 CPI of 236.916.
The result is 0.02500042209. That is a measure of change, in decimals.
You multiply this by 100 and get 2.500042009. You add a %, round it off, and get 2.5%.
That’s the percentage amount of the increase in the CPI for one year.
It looks complicated, because this is the Government, and that’s how they do things.
But it is actually simple.
Here’s what it means. The January 2017 Consumer Price Index of 242.839 increased 2.5% over the January 2016 Consumer Price Index of 236.916. That’s it.
And here is a rundown of the annual Inflation Rate for the last 20 years, not including the last two, which would distort the picture.
If you add all of the rates together, you get 43.
If you divide by 20, you get 2.15%
So the average Inflation Rate for the last 20 years is 2.15%.
Now, let’s look at how all of this relates to our discussion of Real Estate Depreciation.
The best way to do that is by using an example.
Take notes and you’ll see how this works.
Or, if you have trouble juggling numbers, just follow the reasoning and logic, and I’ll keep repeating the numbers.
You have $300,000 to invest.
You buy a Duplex.
You assign $25,000 to the value of the land. That’s low, but I think you can get away with it.
That leaves $275,000 assigned to the value of the building, an amount that you can claim as Depreciation, a non-cash expense that you deduct from income before paying taxes. This is the Real Estate Depreciation that we are talking about today.
You claim this at the rate of $10,000 each year for 27.5 years.
It sounds great, and it is, but not as great as it seems.
Not only do you lose any benefit from the $25,000 land value, which you cannot depreciate, but you also will not recover your entire $275,000 outlay.
Now, remember, you can only compare dollars in the same year, not in different years.
So, although you paid for all of the future annual $10,000 Depreciation deductions in today’s dollars, each year that passes, the actual dollar benefit that you receive from each $10,000 Depreciation deduction, as you take it, is reduced by the annual Inflation Rate.
We’ve shown that annual amount to be an average of 2.15% for the past 20 years.
That means that for each year that passes, the value of your future $10,000 Depreciation deduction is only worth 97.85% as much, in today’s dollars. And today’s dollars are what you spent, and also what you are supposed to be getting back in future benefits, that’s the promise of Real Estate Depreciation.
That 2.15% might seem like such a small amount that it is not worth being concerned about.
But it is, because that $10,000 in Depreciation that you will receive in the future is decreasing in value 2.15% every year until you get to use it.
Now, let’s look at the value of those future $10,000 Depreciation deductions in today’s dollar values.
INFLATION RATES TABLES
We will assume that you bought the property on January 1.
2.15% INFLATION RATE, $10K, 27.5 YEARS
YEAR 1: $10,000 x .9785 (1 x .9785) = $9,785
YEAR 2: $10,000 x .9575 (.9785 x .9785) = $9,575
YEAR 3: $10,000 x .9369 (.9575 x .9785) = $9,369
YEAR 4: $10,000 x .9167 (.9369 x .9785) = $9,167
YEAR 5: $10,000 x .8970 = $8,970
YEAR 6: $10,000 x .8777 = $8,777
YEAR 7: x .8589 = $8,589
YEAR 8: x .8404 = $8,404
YEAR 9: x .8223 = $8,223
YEAR 10: x .8047 = $8,047
YEAR 11: x .7874 = $7,874
YEAR 12: x .7704 = $7,704
YEAR 13: x .7539 = $7,539
YEAR 14: x .7377 = $7,377
YEAR 15: x .7218 = $7,218
YEAR 16: x .7062 = $7,062
YEAR 17: x .6911 = $6,911
YEAR 18: x .6762 = $6,762
YEAR 19: x .6617 = $6,617
YEAR 20: x .6475 = $6,475
YEAR 21: x .6335 = $6,335
YEAR 22: x .6199 = $6,199
YEAR 23: x .6066 = $6,066
YEAR 24: x .5936 = $5,936
YEAR 25: x .5808 = $5,808
YEAR 26: x .5683 = $5,683
YEAR 27: x .5561 = $5,561
YEAR 27.5: $5,000 x .5441 = $2,721
INFLATION AND REAL ESTATE DEPRECIATION
The numbers are OK in the early years, but you start to see the impact at Year 5, when your $10,000 Depreciation deduction is worth $8,970 in today’s dollars.
At Year 10, the value is $8,047.
At Year 15, it has dropped to $7,218.
At Year 20, it is down to $6,475.
At Year 25, it hits $5,808.
In the final year, your $10,000 Depreciation Deduction is reduced to $5,441 in today’s money.
You are not likely to keep the property for 27.5 years, but if you did, you would pay $300,000 for the property in today’s dollars, and only receive $204,753 of Depreciation deductions, in today’s dollars.
That’s a loss of $95,247 in value.
And as a kicker, when you sell the property, you pay a 25% Depreciation Recapture tax on the entire $275,000 of Depreciation that you claimed.
Of course, you will be paying that tax in future dollars, so it won’t be so bad.
If you were depreciating a $3M Apartment Complex instead of a $300,000 Duplex, you would lose $952,470 in value because of Inflation affecting your Depreciation.
So this concept should be of major concern for the larger investors.
REAL ESTATE DEPRECIATION AND INFLATION IN THE FUTURE
There have been a number of attempts over the past 50 years to adjust Depreciation to account for the Inflation Rate, so that you could recover your actual expenditure, but so far the concept has not made it into law.
So, what do we do about it, to make sure that we get the full benefit of our cash outlay in Depreciation deductions?
Well, first, don’t pay all cash for anything.
Except maybe raw land. I’ll explain that in another Blog Post.
Spend as little of your cash as possible. But hold on to the rest of your cash as an emergency fund to reduce the high risk of the leverage that you are using.
SO, HOW TO DEAL WITH IT
I wish that I had one rule, or one formula for this, but I don’t.
However, I can show you a situation that might be close to ideal, and you can use it as a guide.
Let’s say that you could find a $300,000 Duplex with an owner who wants to spread his Capital Gains out over a number of years, and he is willing to do Owner Financing. That way, he would only pay the Capital Gains tax on the Principal portion of the payments as they are received.
You agree to a 20% Down Payment so that you only use $60,000 of your cash, holding the remaining $240,000 and putting it into a safe, liquid investment, earning 5%.
And you agree with the Seller that on December 31 of each year, for 24 years, you will pay him a Principal payment of $10,000 plus 5% interest on the loan balance that existed for that prior 12-month period.
This is also an attractive arrangement for a Seller.
You use the 5% interest income from your own $240,000 investment funds to pay the 5% interest on your $240,000 debt.
Then you take $10,000 out of your investment funds and pay down your debt by $10,000.
You immediately claim $10,000 in Depreciation with the value of the dollars that you paid being equal to the value in dollars of the benefits that you receive.
And that’s it.
Of course, I’m not suggesting that this will work for everyone.
I’m just saying that you should adjust your thinking to always trying to match the dollar value of your cash outlays to the dollar value of the benefits that you are receiving, especially in the area of Depreciation, where it might be 27.5 years before you receive the benefits of those cash outlays.
As you can see, this concept, like most of the world of Real Estate Investing, involves the use of debt. I don’t think there is enough discussion about debt, and I think you might find some interesting information about the After-Tax Cost of Debt on another Blog Post.
I cover this same concept in more than one of my books, but the one with the most detailed information is “Do This, Not That!” and you can find it here on this website. Use the 3D Flip Reader to look at the Contents and read the first few chapters.
The paperback is available on my Amazon Author Page, along with my other books.
And I have related Articles about tax matters from other perspectives on my LinkedIn Page.
I am also active on Quora.com where I have answered over 300 questions, and they have almost 3 Million views.
If you happen to be doing, or if you are considering doing, a Section 1031 Like Kind Exchange, then Depreciation will be a major consideration, and I have a lot of material for you to consider on my S1031 Exchange website.
You should always check out the credentials of anyone, like myself, who you are relying on for accurate information by looking closely at their Biography. Here’s mine.
If you are interested in exploring my Catalog of Real Estate Investing books, but don’t know where to start, I suggest these three.
DISCLAIMER: I am an Attorney licensed to practice in Texas, North Carolina, Virginia, and the District of Columbia. But I am not your Attorney. I would be honored if I were, but I am not. Reading this Blog does not created an attorney-client relationship between us. Internet content should not be used as a substitute for the advice of a competent Attorney admitted or authorized to practice law in your state or jurisdiction.