Because depreciation (or cost recovery) forms the basis for a major part of tax shelter, realtors that work with with real estate investment property and those investing in real estate for renting should understand something about depreciation.

Depreciation (cost recovery) is defined by the tax code as a loss in value to a property over time as the property is being used. In other words, because physical structures (called “improvements”) do wear out, the government (according to rules specified in the tax code) allows property owners to take a tax deduction each year until the entire depreciable asset is written off.

The amount of depreciation deduction is based on the rental property’s useful life (the term used for tax purposes) and not nessarily the actual physical life expectancy of the physical asset. For example, let’s assume the Great Pyramid was built as an apartment complex subject to our current tax code. The owner would not have been able to depreciate it over the the thousands of years it has actually physically endured, but only over its “useful life” as prescribed by the code. (An absurd example, of course, but you get the point).

For a property to be eligible for depreciation, the real estate property must be used in a trade or business or held for the production of income. So an individual’s personal residence does not qualify for depreciation deductions. Moreover, it must be something that wears out or loses its value from natural causes. Therefore only the physical structure and not the land can be depreciated. For example, if you purchase a ten unit apartment complex for $700,000, of which you attribute $490,000 to the building and $210,000 to the land, you can only depreciate $490,000 and not the full $700,000.

Summary

1. The tax code permits depreciation deduction for income property (not one’s personal residence)
2. The useful life (not the physical life expectancy of the asset) becomes the depreciable basis
3. Only physical structures (not land) can be depreciated

We’ll continue to explore depreciation next time. Stay tuned.

The net operating income (NOI) of income property is the sum of money left after the operating expenses have been deducted from the gross operating income (GOI). You might think of it as the amount of money, after rents are collected and all expenses paid, that’s left over to make the mortgage payment. 

Let’s take a look. Assume that a property has an annual GOI of $30,000 and annual operating expenses of $12,000. What’s the NOI? You got it, $18,000 ($30,000 less 12,000 = 18,000). What’s it all mean? It means the property produces $18,000 a year for the loan payment, which (if we did our homework) should be less than $18,000; and better yet, be less enough so we can make the payment and have money left over to put in our pocket (i.e., make a positive cash flow).    

The NOI by itself doen’t say anything about a rental property’s worth. But you will need it to compute cap rate so it helps to become familiar with it and in turn have some understanding about how it fits in to the evaluation process.    

Real estate investors make a common mistake with rental property. They generally make no provision to periodically inspect the units their tenants occupy. And this can lead to some surprising (if not negative) results for the landlord.

Several years ago I had a small twelve-unit apartment complex in escrow subject to a buyer’s walk-thru. The owner kept his units in good condition, plus the units were 100% occupied, so we both the owner and myself anticipated smooth sailing for the buyer inspection and felt that if there was going to be a problem with the property it might occur in a subsequent pest and dry rot inspection. We were wrong. During our walk thru several units were not only filty, one tenant in particular had a stack of tires in the living room piled to the ceiling alongside a massive teepee. Obviously this didn’t set well with Mr. & Mrs. Buyer because they backed out of the deal right afterward without further discussion.

What happened? The owner was lulled to sleep by the fact that his tenants paid their rent on time and were not disruptive and felt no need to periodically inspect the units. But given the age we live in, where drugs and other more deviant behavior is becoming more frequent, an investor must become more guarded and should periodically check in on the tenants just to be sure that things are as binane behind closed doors as they appear on the surface. The remedy? Rental property owners need to a schedule a walk thru of their units maybe twice, but no less than once a year. It might not prevent everything, but it will help.