Depreciation is the recovery of the cost of an asset that wears out. Another term you may see for depreciation on the Real Estate License Exam is cost recovery. Allowing you to deduct depreciation from your annual tax obligation is the government’s way of acknowledging that the asset wears out and that if you didn’t have the asset, you couldn’t earn any money on which to pay taxes.

With depreciation, you wind up paying less in annual taxes on any given piece of property (and keeping more of your profits).

The government wants you to pay taxes. No surprise there. For people who need physical objects like buildings, machinery, or automobiles to earn their incomes and therefore to pay taxes, the government understands that no physical object lasts forever, and without that object you have no business and pay no taxes.

Depreciation is the government’s way of acknowledging that these things wear out and helping investors replace these items so that they can continue earning income and — you guessed it — continue paying taxes.

Here’s a non-real estate example, including the tax impact. Suppose that you have the smallest car rental company in the world with only one car. That car cost \$25,000, and you rent it out and make \$8,000 in what usually is referred to as gross income (income before taxes and expenses).

After gas, oil, maintenance, and insurance expenses are deducted, you end up with \$6,000 left as your net income. You’re in the 20 percent tax bracket, so your tax calculation is

\$6,000 (net income) x 0.20 = \$1,200 (taxes)

At least that’s how much your taxes would be if the government didn’t recognize the fact that cars wear out and without a car you have no business and the government gets no taxes. So, the government lets you deduct depreciation, enabling you to do so during what is called a cost recovery period of five years on the car.

\$25,000 (cost of car) ÷5 (cost recovery period in years) = \$5,000 (depreciation per year)

So now, instead of deducting only \$2,000 in expenses from your income, you get to deduct another \$5,000.

\$8,000 (gross income) – \$2,000 (operating expenses) – \$5,000 (depreciation) = \$1,000 (net income)

\$1,000 (net income) x 0.20 (tax rate) = \$200 (taxes)

A tax bill of \$200 versus \$1,200, courtesy of depreciation, sounds pretty good. And you thought those guys at the IRS were only after your money.

Investment properties benefit from the same depreciation calculation; however, the cost recovery period for buildings is longer than for motor vehicles, and vacant land can’t be depreciated at all, because land doesn’t get old and worn out like a building. And a private home can’t be depreciated because it isn’t considered an income-generating asset.

The type of depreciation that is used for investment properties is called straight-line depreciation, because an equal amount of the value of the building is deducted each year. The government periodically changes the rules governing the cost recovery period, the required ownership time, and the tax rate at which capital gains generated from depreciation are taxed.

Because state exam writers don’t want to have to change exam questions every time the federal government changes the tax law, you probably won’t get any questions on the specifics. But you may get a question about deprecation in general, how it works, and how it affects the basis.

The beauty of depreciation is that it’s subtracted from annual income thereby reducing your annual tax burden. Because depreciation reduces the adjusted basis of the property, it increases the capital gains on which you’ll have to pay taxes. But capital gains are traditionally given favorable treatment by the tax code, so ultimately you’re paying less tax on the capital gain than you would have on the annual income.