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D is for Depreciation

By
Real Estate Agent with Keller Williams Realty

Just to recap, the mnemonic IDEAL spells out the 5 reasons why real estate is a great investment. Last blog we talked about the first one, now we'll go onward.

I is for Income

D is for Depreciation

E is for Equity

A is for Appreciation

L is for Leverage

Plus we added M for Motivated (sellers).

Now on to "D for Depreciation!"

Depreciation is a fiction invented by the IRS. The fiction says that when we buy a property and place it in rental service, that property has a fixed service life of 27.5 years; in other words, in 27.5 years it is considered "used up." And so, the owner is allowed to take the purchase price of the property, divide it by 27.5 years, and each year enter the resulting figure on their income tax return an "expense" of operating the rental property.

Depreciation is a "paper" loss, in the sense that it really didn't cost us that money to operate the rental property, BUT we still get to deduct it from our rental income as an expense. This reduces our tax liability that year.

This is, of course, a gross oversimplification and you'll probably need an accountant to help you treat depreciation properly.

But depreciation is pretty neat nonetheless; the IRS helps you in your rental business! Why would they do this? 

As a matter of Federal policy, the government provides some services directly, like Medicaid and Medicare and food stamps. A great many other services they provide indirectly through the use of tax incentives. For example, the government gives special tax status to non-profit entities; this is so they have an extra incentive and greater ability to do their good works. The good works get done, and partially funded by the government in the form of a tax exemption, without the government being directly involved. In a sense, they have pushed some of the work to the private sector.

It's the same with depreciation; it provides an incentive for private investors to provide rental housing across the country, which is in the common interest. 

E is for Equity.  Equity is the value of the asset (real estate) has once the liabilities (debt) are subtracted. If you buy a property for $200,000 with 20% down, your loan amount is $160,000; your equity is $40,000. Equity in real estate investments goes up as property values go up (and down as they go down, as many have found out painfully in the latest bubble-bust cycle). Also, as monthly payments on the loan are made, the balance on the loan is reduced and the equity increases (except for certain types of loans, but that's another topic altogether!).

That brings us to A for Appreciation. Historically, real estate appreciates or goes up in value. The long-term appreciation of real estate in Florida is between 5% and 6%. The current downturn looks like disaster, but if you talk to Realtors who have worked in the field for 40 years, you'll hear them say, "We had a real bad downturn in the '70s ... and another one in the '80s ... and another one in the '90s." So to them, this latest crunch looks like just another cycle (except that interest rates remain LOW right now, which you couldn't have said about the other cycles).

The point is that, cyclical corrections aside, real estate has appreciated pretty well.

Appreciation can be short-term and local as well. For instance, a new commercial development nearby can boost appreciation in a small area, over a very short period of time.

That brings us to L is for Leverage.  If you have $200,000 to invest, you can buy $200,000 worth of gold, or diamonds, or stocks, or bonds. Or you can buy $1,000,000 worth of rental property -- because of leverage. 5 houses at $200,000 each is a million dollars' worth of property. But you'll borrow 80%, and put 20% down. Operate your rentals, use the income to pay your loan balances down, and wind up in the long haul with five free-and-clear income-producing properties!

Sounds easy? It's not, but it's do-able. More later on that.

So that's I-D-E-A-L. We added M for Motivated (sellers) to come up with M-I-D-E-A-L. We'l talk about that next time!

Comments (2)

Christine Donovan
Donovan Blatt Realty - Costa Mesa, CA
Broker/Attorney 714-319-9751 DRE01267479 - Costa M

I really enjoyed this as a clear and concise way to explain things that may seem obvious to those of us in the industry.

Jun 07, 2008 01:13 PM
Susan Hilton
CENTURY 21 Beal, Inc. - College Station, TX
Texas Aggie Real Estate, College Station Bryan Texas Real Estate

Very clear way to explain unclear items.

Jun 07, 2008 01:42 PM