What is depreciation in real estate and how does it benefit your investment?
A new car is said to depreciate in value the second you drive it off the lot. In fact, a car loses an average of 60% of its value within 5 years. As a result, a new car is often considered one of the worst possible investments you can make. On the other side of that spectrum, a home, or real estate investment, is commonly considered one of the better investments you could make. Why? Because unlike a car, a home or building often holds or increases in value over time.
Although depreciation often means that an asset’s market price is losing value, it’s not always that straightforward. In fact, due to the accounting method of depreciation, the value of a real estate asset may be reduced on a balance sheet while its market price is held steady, or increasing.
What is depreciation?
While in the example above, depreciation is clearly a negative for the owner, in real estate, depreciation can be very beneficial from a tax perspective. In short, depreciation allows a company to write off the value of an asset over its determinable useful life. This is not limited to just real estate. Examples of other assets that may be depreciated include office equipment, industrial vehicles, and buildings. The major exception here is land, which cannot be depreciated because it is assumed to have an unlimited useful life. A residential property typically depreciates over 27.5 years, while the useful life of a commercial property is 39 years.
How does this benefit a real estate investment?
By writing off the depreciation of an asset, a company may reduce the amount of tax they pay on the net income produced by that asset. For example, let’s say a company purchases a property for $1 million with the intention of renting the units. The gross annual income of this property is $75,000, which is generated from rental income. The property’s expenses, including repairs and salaries, total $25,000, leaving net annual income at $50,000. Without depreciation, the property owner would pay taxes on the entire $50,000 of net income. However, because of depreciation, the company can subtract $36,363.64 (purchase price of $1m / 27.5) from the taxable amount each year. This process continues for 27.5 years, until the property’s useful life has expired. This translates to over $10,000 saved in income taxes every year.
|Purchase Price (excluding land and fees)||$1,000,000|
|Gross Annual Income (rent, etc)||$75,000|
|Total Annual Expenses||$25,000|
|Net Annual Income (Gross Income – Expenses)||$50,000|
|Depreciation ($1 mil / 27.5)||$36,363.64|
|Income Subject to Tax(Income – Depreciation)||$13,636.36|
The example above is for explanatory purposes only and is not representative of any investments on the Fundrise platform. Please consult your CPA or tax professional for tax information specific to you.
How depreciation benefits your Fundrise investment
Although your investment with Fundrise is diversified within a fund (or across multiple funds) and not allocated to one particular property, this asset level tax break may still benefit you as an investor. The benefits of depreciation affect your investment in slightly different ways, depending on whether you have invested in an eFund or an eREIT.
For the eFunds, depreciation will reduce the the taxable income of the fund. Because the eFunds are pass through entities, the investor will pay less in taxes on their allocable share of fund taxable income while their cash distribution is unaffected, translating to a potentially higher return. If the above example were to hold true across all assets, this equates to roughly $10,000 saved in taxes for every $1 million invested in equity. Each of Fundrise’s offerings can raise $50 million per year, so this tax benefit can become significant at the fund level.
For the eREITs that hold equity investments, depreciation still impacts your investment - though slightly less directly - by reducing the taxable income of the fund. Let’s say, for example, that a REIT’s taxable income for a given year is $100,000. Before taking into account depreciation, the fund would be required to distribute $90,000 (90%) to qualify as a REIT and not pay taxes at the fund level.
If the above asset were part of this fund, it would reduce the fund’s taxable income by $36,363.64 to $63,636.36. This means that the fund would instead only be required to distribute $57,272.72 (90% of $63,636.36) instead of $90,000. Should the fund, however, still decide to distribute the full $90,000 or even just part of that difference, anything distributed in excess of $57,272.72 would be considered a non-dividend distribution. A non-dividend distribution is often advantageous because it is not immediately taxable. Paying taxes later is almost always desirable because that capital can be invested to generate returns elsewhere instead of being paid to the IRS today. A non-dividend distribution is ultimately taxable when you dispose of your investment, and provides yet another advantage because it is taxed at the potentially lower long-term capital gains rate. For more information on how non-dividend distributions are taxed, you may find this case study helpful.
Ultimately, depreciation makes real estate a uniquely tax efficient asset class. Such a tax benefit is not available when investing in public equities or fixed income, since neither of these assets are tangible items and they hence cannot be depreciated over time. Going back to our initial example of a car, depreciation frequently means that your investment is losing value. However, with real estate, assets can lose value on a balance sheet while actually gaining value on the market, making them a highly desirable asset class to diversify a portfolio.