Understanding Depreciation in Real Estate

Mid-Day Market News & Commentary by Chris McLaughlin, December 3, 2008
http://www.shortsalesriches.com/welcome.html

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In the latest on the botched government bailout, the Government Accountability Office blasted the internal controls over the handling of the $700 billion allocated for the TARP bailout. The report specifically noted that the ultimate outcome – providing liquidity and getting banks to lend –is not being monitored. As it notes: “Treasury has no policies and procedures in place for ensuring that the institutions are complying with these requirements or that they are using the capital investments in a manner that helps meet the purposes of the act.”

So let’s give the banks $300 billion … but put no requirements that they actually lend it. Hmm… and guess what’s happening? They are hoarding the cash, so Main Street still gets hurt. Our bet: the next $350 billion that goes out has a lot more strings attached to it, not just restrictions on executive pay and dividend payouts.

And in the latest sign of desperation from the Big 3 Automakers, Jim Press, the Vice Chairman of Chrysler said the big D work: depression. “We’re on the brink with the U.S. auto manufacturing industry,” Press told The Associated Press. “If we have a catastrophic failure of one of these car companies, in this tender environment for the economy, it’s a huge blow. It could trigger a depression.”

Depression? Really? That’s really pushing the envelope folks. First they fly in with corporate jets asking for help. Now they’ve gone to scare tactics because the American people are not happy about another bailout. How about designing cars that are fuel efficient? Novel idea, eh?

President elect Barack Obama nominated New Mexico Governor Bill Richardson as the Secretary of Commerce. “We have everything we need to renew our economy, we have the ingenuity and technology, the skill and commitment — we just need to put it to work,” Obama said.

Now on to our real estate educational section …

Understanding Depreciation—Especially on Short Sales & REOs

When it comes to buying and selling short sales, foreclosures or other distressed real estate an understanding of depreciation is essential. To begin, let’s use a working definition of depreciation; depreciation is simply an accounting method of reducing accounting income by spreading the deductible fixed asset cost over the estimated life-span. Two questions should quickly come to mind; “what is a fixed asset” and “what is the estimated life span”?

When dealing with real estate the house and property are considered “fixed” assets; other items such as appliances are also assets but not long term. For tax planning purposes, the government has established typical life-spans associated with most assets; for example, buildings often have a life-span of 27.5 years, appliances 5 to 7 years etc…land, which doesn’t deteriorate or become obsolete, never depreciates.

There are several ways to calculate depreciation depending upon your specific needs and situation but it is important to understand the benefits and consequences of each; once you select a method it is difficult to impossible to change to another formula in future years. The two most common methods are the straight-line and units of production however, for the purpose of real estate, most short sale investors will only use the straight line formula.

The straight line formula is easy: Depreciation = cost-salvage value/number of years of useful life. So for example, if you purchase a new HVAC unit for a home at a cost of $5,000 then subtract a salvage value of $500 for a total of $4,500 divided by a 10 year lifespan you would derive an annual depreciation of $450.

Alternative depreciation calculation methods include “Sum of the Years’ Digits” and “Double Declining Balance” are useful when additional depreciation is needed earlier in the lifecycle of the asset. Keep in mind, whatever method is used, the total depreciation will result in the same amount by the end of the period. It is only the annual amount of depreciation that changes.

A few depreciation tips to keep in mind related to short sales:

1. Bonus depreciation is currently authorized for investment properties – this accelerated depreciation is a major tax advantage to those seeking a shelter or hedge against gains. If you currently need additional tax breaks then take it; otherwise, use the standard straight line depreciation method without the acceleration.

2. Calculate depreciation when crunching numbers; depreciation can turn marginal homes into the black rather than the red.

3. Consider selling or doing a 1031 exchange on properties nearing their full depreciation schedule; be careful to calculate depreciation recapture.

4. Depreciation isn’t optional; short sale investors that fail to take depreciation will still be liable for it later.

5. Always review accumulated depreciation expenses reported on income statements/other of investors/sellers etc; accumulated depreciation on a fixed asset is a solid method of determining book value and the real “worth” of a fixed asset.

Understanding Depreciation in Real Estate

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