Real estate depreciation and capitalization rates are two essential concepts for rental property owners to understand and use to their advantage.
The former can save homeowners thousands on their tax bills, while the latter provides a quick assessment of a home’s income-generating potential relative to its cost or perceived worth.
Commercial real estate developer from Staten Island, New York, Joseph Rizzuto says that without a sound understanding of these terms, it is nearly impossible to judge the potential value of rental property investment accurately.
Let us take a closer look at what each of them means for homeowners and investors.
How to Calculate a Property’s Cap Rate
Cap (or capitalization) rates are beneficial for determining the relative annual return of a rental property as an investment, as well as its ultimate resale value.
The calculation itself is straightforward, boiling down to the property’s annual net operating income (NOI) divided by its present value. Thus, a home with an NOI of $10,000 and current value of $200,000 would have a cap rate of 5%. Investors would compare that figure with other investment opportunities available to judge whether it is right for them.
Homeowners or investors can also calculate whether improvements to the home will strengthen or weaken its cap rate by estimating the cost of the improvements, the resulting increase in the value of the home, and the potential increase to its income generating capability as a result.
If the improvements will cause the property to increase in value without its NOI likewise increasing, it would likely make it less desirable to income investors who are looking primarily for the best return on their investment dollars according to Joseph Rizzuto.
Why Real Estate Depreciation is Great for Property Owners
On the surface, real estate depreciation does not sound at all appealing. Naturally, no investor wants the value of their assets to decline. Thankfully when it comes to real estate, that rarely happens. Though logic would seem to dictate that homes should lose value over time in the same way a vehicle does, history has largely shown that not to be the case.
Nonetheless, the IRS allows homeowners whose properties are used for business or rental activities to make an annual deduction against them based on the assumption that they have fallen in value due to wear and tear. This also applies to any capital improvements made to the home.
The depreciated value could even exceed the amount of rental income the property generates says Joseph Rizzuto, making it come out as a tax loss.
When it comes to rental properties, they have 27.5 years of “useful life” as prescribed by the IRS, meaning they theoretically lose 1/27.5 of their value each year. That amount is multiplied by the homeowner’s marginal tax rate to arrive at the figure which can be deducted.
Joseph Rizzuto points out that this depreciation applies only to the home itself, and not to the value of the land the home resides on, which the IRS does not consider to be losing value over time. Thus, homeowners need to determine the value of only the buildings, which can be done through a tax assessment.
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