QUOTE (Nukav @ Oct 16 2009, 02:30 PM) "As someone who has a quote from Robert Kiyosaki as their signature, I am shocked you would suggest that."
Maybe you dont argue with your accountant as much as I do. (smile) but I would say that the definition of an asset is TOTALLY differant depending on who`s perspective you are getting! (and what is used for) Just a thought. cheers.
Depreciation is a very important tax tool for the real estate investor with equity in his/her property.
As mentioned before depreciation is only regarding buildings and equipment NOT on land. Land does not depreciate in fact as most of us know, it tends to appreciate.
Depreciation basically means that something is being used up or consumed. Like the earlier mentioned car lease; this is basically a `pay as you go system`. You pay that portion of the car that you used up. The car company uses an estimate how much that is, some leases therefor only allow you to drive a certain number of kilomaters per year. If you drive more, you wear out the car more than anticipated by the leasing company.
The same is true for buildings. Typically, a building has a useful life of between 25 and 30 years depending on its type and use. Of course, you can augment the life when you maintain or renovate the building. So suppose you have a $100,000 building and a useful estimated life of 50 yrs, then the building depreciates or consumes $100,000/50 is $2,000 per year. So after one year the building`s depreciated value is 100,000-$2000 = $98,000 and after 10 years your building`s depreciated value is $100,000 - 10*2000 = $80,000 Got it this far?
So after 10 yrs we do a major reno for $10,000. Now we have depreciated the building down to $80,000 but we also added $10,000 in improvements and thus the new depreciated value is $80,000 plus $10,000 = $90,000. You have also extended the useful life of your building thanks to the reno. Say by 5 years. So now your new annual depreciation is $90,000/(50-10yrs+5yrs)= $90,000/45yrs = $2000 per year. (Oops, this just happen to be the exact same amount as before the reno - that is just coincidence).
Your accountant knows the official percentages for depreciation that is allowed by Revenue Canada. Eh, you may say, what has depreciation to do with taxes? You bet that it is important for your taxes, because it makes having positive cashflow extremely attractive. Much more attractive than interest on an RRSP or a dividend from a stock or a company (except when you are investing within an RRSP or TFSA because there you don`t pay taxes on positive cashflow).
But outside RRSPs you pay do pay taxes on your net rental income or positive cashflow. DEPRECIATION CAN ONLY BE USED WHEN YOU HAVE POSITIVE CASHFLOW - if you have negative cashflow the depreciation is basically `deferred`!
If depreciation is the value decrease due to the use of your building then it is obviously an ... EXPENSE. So if you make a profit after deducting all your operational, financing and propery tax expenses, then rather than paying taxes equalling your marginal tax rate times your positive cashflow, you can use ONE MORE EXPENSE to reduce your rental income sometimes all the way to zero - YES DEPRECIATION MAKES RENTAL INCOME TAXFREE... until you have completely depreciated your building.
Some disadvantages:
1 When you sell the building your cap gains are now a lot more. They are Proceeds of sales minus the Purchase costs PLUS DEPRECIATION DEDUCTED during your time of ownership. This can be quite substantial. BUT you have to realize that first of all, you deferred paying taxes for many years and used this cashflow for new investments (or your BMW).
2 Secondly, you pay less taxes, because when deferred your deferred taxes were based on your marginal tax rate x depreciation. Now you have to pay taxes based on CAPITAL GAINS so... you pay only back marginal tax rate x depreciation DIVIDED BY TWO(2)!!
If you make negative cashflow during a year, i.e. you subsidise your renters, then you CANNOT depreciate the building that year. BUT (and there always is a BUT)... BUT the depreciation value stays the same that year and you can use it once you get positive cashflow.
Finally, it is depreciation that makes building up a large equity position in a property so attractive. Because depreciation makes positive cashflow nearly entirely tax free (remember repayment upon disposal). There is no other form of income that does so!!
I have to run. Hope this helps
P.S. I am NOT an accountant - so if you want to use depreciation talk to your accountant!
