Owning real estate offers many significant tax advantages that other investments don’t.
Perhaps the most notable tax advantage is the ability to write off the cost of depreciation.
Depreciation is a “phantom expense” that the IRS allows real estate investors to deduct from their taxable income each year to account for the natural wear-and-tear that occurs to the physical improvements of a property.
The word “phantom” is often used because this expense doesn't have a tangible negative impact on the property owner's bank account. It's a paper loss that reduces the investor's taxable income and effectively reduces their annual tax obligation, even if there are no direct capital expenditures for the property in that tax year.
This ultimately means the real estate investor gets to keep more money and pay less to the government each year.
A building can be depreciated, but land cannot (i.e., buildings and equipment will eventually wear out and need to be replaced, but dirt doesn't).
Likewise, certain types of buildings and equipment will wear out faster than others, so to calculate this number correctly, it's important to understand a few key things:
Doing this correctly will allow the property owner to save significant tax dollars each year (and when the property is eventually sold).
Doing this incorrectly will result in unnecessary tax expenses or penalties, so it's important to get this right!
As mentioned above, this process starts with establishing an appropriate value for the subject property… but when we're talking about real estate, “value” can be very subjective.
In the real estate industry, there are different ways to determine what a property may be worth, here are a few of the most common methods…
When most properties are bought and sold, an appraisal is performed by a professional appraiser.
An appraisal is an unbiased assessment of a property's value, accompanied by supporting data to support the validity of the valuation. Appraisers will typically use the income approach, the sales comparison approach, and/or the cost approach to determine the most realistic value of a property.