Real Estate Genius Investment Software Blog

Got a great question from a client the other day. In summary, “What exactly is depreciation?”

I suspect that this is a concept not well understood by the non-accountants out there. Speaking for myself, a non-accountant, I had a rough time with it until one fateful night in business school when I finally saw the light. So here’s a primer in a nutshell…

An old asset is, generally speaking, not worth as much as a new asset. Things wear out. For example, I think of my first car, a styling Plymouth Volare handed down from my grandpa. At one point in time, it was a new car and worth 100% of its purchase price. By the time I got it, well, it was worth somewhat less than that. And then by the time I had passed it off to my brother, who passed it off to a cousin, who abandoned it somewhere in the swamps of Jersey… well, it wasn’t worth much at all by that point.

When the asset is originally purchased, it is placed on the balance sheet at its purchase price. ‘Depreciation’ is the means by which you continually adjust the value of the asset downwards, so that the asset value more closely reflects reality. Uncle Sam is glad to lend a helping hand, by decreeing the rate at which you are allowed to depreciate a given item. Why does Uncle Sam care? Because every time you depreciate an asset, you write off part of its value as an expense, which reduces your income and therefore reduces your tax burden. Thus, it is in your interest to depreciate as fast as possible, while it is in the IRS’ interest to make you depreciate as slow as possible.

Depreciation is entirely a ‘paper’ rather than a ‘real’ transaction. No cash ever changes hands. For this reason, depreciation does not affect cash flow. That’s why when you look at a cash flow statement, you’ll see that depreciation is added back to net income (since it was deducted from revenue on the income statement, it needs to be added back).

In the case of real estate, there is an extra twist thrown in- when you buy a building, you are generally buying both the building as well as the land it sits on. Buildings wear out, but land doesn’t. As a result, you can only depreciate the portion of the purchase price attributed to the building. That’s why when you analyze a property in Real Estate Genius, you are requested to estimate ‘% of purchase price allocated to building’. So if you plan to buy a property for $100,000, and 80% of the value reflects the building, you will start depreciating from $80,000.

If you’d like to learn more, check out this more thorough explanation of the process which I came across online:
http://www.dignitymortgage.com/Investing/Investment_Property_Tax_Adv3-DeductingDepreciation.htm

I hope this gives you better picture of depreciation!

Now this is a cool website - www.zillow.com. This website attempts to tell you what a house is worth right now. Just type in an address, any address - your house, your parent’s house, your boss’s house, your ex-wife’s house. Instant cocktail party conversation!

How accurate is it? It apparently depends on where you live, as some areas of the country are better served than others. Zillow claims that most valuations are within 10%, so hey, this is a great place to start from. Zillow will also show you all of the comparable homes in a neighborhood, as well as past purchase history of a property. Best of all, it’s free, easy to use, and fast.

I suggest utilizing Zillow when doing property analysis with Real Estate Genius - this way, you can analyze a property using both the asking price as well as Zillow’s estimate. Use the Zillow estimate as a negotiating tool (assuming it’s lower than asking price). Plug the Zillow estimate into the Real Estate Genius calculator, and use the resulting financial statements to show the seller why the price is too high. It’s a brave new world.