Definition:
Depreciation is the decrease in a property's value over time due to wear and tear, age, or changes in the market or surrounding area.
Example:
Tom bought a rental property ten years ago for $250,000. Over time, the roof aged, the kitchen became outdated, and newer homes were built nearby. As a result, the property's value dropped to $220,000. This decrease in value is considered depreciation.
Explanation:
In real estate, depreciation affects both property value and taxes. For homeowners, depreciation is generally a sign of declining property condition or market value. However, for real estate investors, depreciation can be a useful tax tool. The IRS allows property owners to deduct a portion of the property’s value each year as it “wears out,” even if the market value is increasing. This is called depreciation for tax purposes and applies only to income-producing properties, such as rental homes or commercial buildings—not personal residences.
Depreciation is calculated over a set number of years—27.5 years for residential rental properties and 39 years for commercial properties. This deduction can reduce taxable income, helping investors save money on taxes while still earning rental income.
Why is Depreciation Important in Real Estate Transactions?
Depreciation matters because it impacts both the perceived value of a property and its tax treatment. For buyers, understanding depreciation helps assess whether a property may require future repairs or updates, affecting maintenance budgets and resale plans. For sellers and investors, depreciation can influence financial planning, pricing strategies, and tax savings.
Additionally, when a property is sold, any previously claimed depreciation must be “recaptured” and taxed, which affects net profits. Knowing how depreciation works helps buyers and sellers make smarter decisions and avoid costly surprises in real estate transactions.