Depending on the country where you live, you may be able to take advantage of certain tax depreciation deductions, when it comes to buying real estate. This tax deduction, is usually an annual allowance for wear and tear, deterioration, or obsolescence of your real estate investment.
For the purposes of real estate investments, it's a non-operational expense that can be used to your advantage come tax time. In the United States, your depreciation is calculated as an expense, based on tables the government provides, showing you the number of years that you can depreciate your property. The depreciable years are vastly different depending on the asset. For instance, residential investment real estate is 27.5 years, while commercial real estate is 39 years. The basic equation for figuring depreciation is:
Total Asset Value (less) Land Value (divided by) Depreciable Years = Annual Depreciations
Let's discuss an example, to better illustrate this concept. Let's say a building (with land) has a value of $19.7 million. In order to estimate your depreciation, we have to first subtract the value of the land, since most governments do not consider land to be a depreciable asset. Depreciation only accounts for the building on the land, since they will lose value as they age. Let's say the estimated value of the land is $3 million. Now let's calculate your yearly depreciation based on the a government table of 27.5 years.
$19,700.00 (less) $3,000,000. (divided by) 27.5 years = $607,273
Now why is depreciation important. Remember depreciation is treated as a non-operational expense. Therefore you can take that annual depreciation of $607,273 per year, and off-set your cash flow. This is a tremendous advantage come tax time. Review the following to better grasp the concept.
$19,700,000.00 - Purchase Price
$ 3,000,000.00 - Land Value
$16,700,000.00 = Total Depreciable Value
$607,273.00 - Annual Depreciation
Now look at how that applies to a simplified property financial
$2,200,000.00 - Rental Income
$ 500,000.00 - Other Income
$2,700.000.00 - Total Income
$1,500,000.00 - Operating Expenses
$1,200,000.00 - Net Operating Income
$ 900,000.00 - Debt Service
$ 300,000.00 - Cash Flow
$ (607,273.00) - Depreciation
$ (307,273.00) - Net Income After Depreciation
Before depreciation, you would be required to pay taxes on the $300,000.00 in cash flow. Depending on your tax rate, that can be a chunk of change. But if you apply your annual depreciation to be subtracted from your cash flow, you basically end up with a $300,000 loss, instead of a $300,000. gain. This means, you don't have to pay taxes.
Money tends to produce more money - when invested right. With this example scenario, the property producing $300,000.00 per year in tax free cash flow. You are then able to use this money to leverage more investments. Each time we take advantage of our leveraged return on our money and our tax free cash flow, this allows us to steadily compound our investment potential, increasing our net worth.
Depreciation may not be applicable in all countries when trying to invest, but for those countries who do allow it - it is a serious consideration when purchasing real estate.