How Appreciation and Depreciation Can Help You Maximize Your Real Estate Investment
Of all the things that make real estate investment such a smart move, appreciation and depreciation are one of the most interesting. In this article, you’ll learn the difference and why it makes real estate not just profitable, but also lucrative.
First Thing: Money Changes Its Value Over Time
Although it is said “a dollar is a dollar”, the reality is that the value of money fluctuates over time. A dollar could be worth less or more in regards to another metric (like the price of gold, or a euro) and that will affect all goods and services that exist in the economy.
It is all based on supply and demand in the market, and also on the sentiment of investors. As Ray Dalio says, “What we call the economy is the sum of very few pieces, small transactions between people and institutions, and each influenced by human nature and interaction. As a whole these interactions make up the economic machine.”
So the fundamental reason why something would be worth more, is because there is a greater demand for it in the market and less supply. On the contrary, an asset would depreciate when the demand for it lowers and the supply rises. All of these changes in prices are reflected in price charts and indexes, which give a visual representation of how assets change value over time.
There can be other factors that influence prices beyond supply and demand, like changes in the value of money (in other words, inflation or deflation) and interest rates changes. As financial bubbles show, even market sentiment can greatly influence price, as it happened during the Dutch Tulip Bulb Market Bubble.
Appreciation vs Depreciation
Before we jump into the main topic of this article, let's level set on definitions. Appreciation means the increase of the value of an asset over time. On the contrary, depreciation is the decrease in the value of an asset over time.
Not all assets are created equal when it comes to appreciation and depreciation. For example, it is known that automobiles, computers and machinery tend to depreciate over time. But when we talk about investments like real estate, stocks or precious metals, the expectation is that they rise in value so there is a profit made for investors. This is influenced by the useful life of an asset, which in the case of real estate can be decades-long (27.5 years for residential and 39 years for commercial, according to the IRS. As for land, it never depreciates).
Real Estate Appreciation
So if you buy a house for $120,000 cash, and the house appreciates 5% in a year, that same house is now worth $126,000 and you have made a profit on your money (as long as you have beaten inflation). As we talked about in this article, the magic happens when you use leverage to invest a $25,000 down payment and your asset value goes from $120,000 to $126,000. Using the power of leverage, your asset increases its overall value, not just by the amount you specifically invested.
Some people buy property just for the expectation of increased future value, which is not a strategy that we’re proponents of. But when you take into account the appreciation plus cash flow from the asset, the overall returns are much more attractive.
According to an article by Mashvisor, there are 6 things that drive real estate appreciation:
Land
Location
Future development plans
The physical structure
The economy
Interest rates and lending guidelines
Demographics and materials can also influence appreciation. That is why, unless you want to sit down to do complex calculations and understand the market sentiment, you need a professional to guide you in your acquisition.
An investor can also make repairs and improvements that drive the value of the property up. By improving an apartment you not only improve the quality of life for the tenants but the actual value of the building. This is called forced appreciation and is a factor that really drives up the potential return on an apartment.
When you invest in a real estate syndication, you have part ownership in a physical asset that can provide great returns when exiting or selling the investment. In fact, investment in apartment buildings has been called a “recession-proof” way to invest your money.
Real Estate Depreciation
In general terms, real estate depreciation means that the value of the property lowers over time. However, if you foresee this and calculate the depreciation, you can end up paying fewer taxes. Here's how.
What many stock investors don’t know is that real estate depreciation can offset other ordinary income to lower your taxes. Tax depreciation can have tax benefits, and it’s one of the reasons why most rental property owners pay very few taxes on the rental income their properties generate. Through it, you can deduct the cost of acquiring an income-generating property over many years.
Although you should always consult a CPA for your specific tax questions, let us say here that real estate depreciation is one of the reasons why owning a property can be such a great investment. It will be an income tax deduction that allows a reduction in the investor’s taxable income.
Here are some other facts about real estate depreciation:
Only the building depreciates, the land does not.
Depreciation is calculated with the IRS useful life standard. This means 27.5 years for residential property and 39 years for commercial property. Land never depreciates.
You need a qualified CPA to help you calculate your after-tax investment returns.
In order for an investment property to depreciate, it needs to be available as a rental. This doesn’t mean that a tenant is there, but it should be a rental property.
There are certain criteria in order to apply for depreciation: a) The asset must be owned by you; b) It must be used for rental income; c) The asset must have a useful life of more than one year; d) It’s useful life can be determined (IRS standards are used).
A cost segregation study determines the construction cost or purchase price of the property to establish all property-related costs that can be depreciated below the IRS time standard. This way, you can speed up the rate at which you depreciate the assets, and thus have greater tax benefits.
In summary, passively investing in real estate generates passive income, which is taxed at a different (and often lower) tax rate than active income from your day job. And as an apartment building ages the owners can depreciate not just the building structure, but also the contents of the buildings (yes, everything right down to the kitchen sink). This can result in a huge deduction for investors when taxes knock on the door.
The Magic of Real Estate
With real estate, you get regular payouts with rental income. In addition, you can make money if and when the asset appreciates with a nice exit. And even if the property depreciates, you’ll get tax benefits that every sophisticated investor will know how to maximize.
That is why a good real estate investment beats any other investment vehicle on the planet. And with the help of Titanium Investments, you can now get your foot in the door of this lucrative investment strategy.
Our mission is to make investing in apartment communities easy and stress-free for investors like you, while providing passive income to enjoy the life you've always dreamed of. Benefit from the power of real estate investment today by scheduling a call with one of our trusted advisors here.