I do NOT understand depreciation. Can somebody help me? I need it explained like a 5 year old.

[customerserviceguy]

23. I haven't done taxes professionally for about twenty years, but here goes

When you buy things that are used to produce income in either an investment or a business situation (not like work clothes for your job, for example) you get to subtract what you paid for those things from the income you get from them. Some things have really short useful lives, or are pretty insignificant, like envelopes and paper for the bills you send out in a business. Some things you have to deduct from the proceeds of the eventual sale, but not before then, like the price you pay for some shares of stock.

Many things that one buys for business or investment have a really long useful life. Unless there is a tax break allowing you to deduct their value in the year of purchase (happens for business property, but generally not for investment property) you have to spread the cost of the item over a useful life. Tax rules often specify this life, and just how fast you can take those deductions against the income from the activity they're used in. Sometimes, as in the case of a newly started business, or a rental residential property, the non-depreciation expenses exceed the income from the activity. Depreciation often leads to an increase in the loss, or the wiping out of a tiny profit from the activity, and you get to deduct the resulting loss against other income that you have coming in.

This often happens with rental real estate. In the early years, rents don't cover mortgage interest, taxes, and maintenance, and you get to "recover" a portion of the building's purchase price through depreciation deductions. These shield income from your wages or your profitable investments, by offsetting the loss against the income from those gainful activities. In "normal" markets, real estate doesn't really go down in value, and when you finally sell the building, you have to "recapture" the deductions you took for depreciation that didn't really occur. One of the great tax breaks is that while you were using that depreciation to offset regular income dollar-for-dollar, when you recapture, you get to use favorable capital gains tax rates on the "recaptured" gain, at least to the extent that it corresponds to straight-line depreciation (that which would be taken evenly over a period of years) versus any accelerated depreciation (that which is taken over what would be allowed as straight-line depreciation).

Eventually, you pay taxes on the amounts you deducted in earlier years, but those taxes are deferred, and the capital gains tax break makes it even sweeter. Let's say you lend me $100, and I have to pay you that $100 ten years from now, no interest. I win. Well, if I have to pay you only $25-$40 dollars ten years later, hey, I really win!

It makes real estate a great investment in good times. Lately, it's not that good.