How Do I Factor in Depreciation in Buying an Apartment?

If you and your significant other are considering buying an apartment building for investment purposes, you can factor the benefits of depreciation into your investment decision. Annual depreciation expense is a part of the property's cost that the Internal Revenue Service allows you to deduct annually. This deduction lowers your income taxes and increases your investment property's after-tax cash flow.

An apartment building's annual depreciation deduction equals the property's total cost minus the land value, divided by 27.5. The IRS does not allow you to depreciate land.

For example, assume you plan to buy an apartment building for $925,000, which includes an estimated land value of $100,000. The apartment’s annual depreciation would be $925,000 minus $100,000, divided by 27.5, which equals $30,000. This means you could deduct $30,000 annually from the property's income to reduce your taxes.

Net operating income is the annual profit an investment property generates before accounting for loan payments or income taxes. NOI equals estimated annual rental income minus estimated annual operating expenses, which include items such as property taxes, utilities and maintenance costs.

For example, assume your apartment building will generate $200,000 in rental income and have $90,000 in operating expenses. Its NOI would be $200,000 minus $90,000, which equals $110,000.

Taxable income on an apartment building equals NOI minus loan interest payments minus depreciation. Annual tax expense equals taxable income multiplied by your tax rate.

For example, assume you estimate you will have $110,000 in NOI, $40,000 in annual interest expense, $30,000 in depreciation and a 30 percent tax rate. Your apartment's taxable income would be $110,000 minus $40,000 minus $30,000, which equals $40,000. Your income tax expense would be $40,000 multiplied by 30 percent, or 0.3, which equals $12,000.

After-tax cash flow is the cash you pocket annually after paying all of your apartment building's expenses and taxes. After-tax cash flow equals NOI minus loan payments – including principal and interest – minus tax expense.

Using the numbers from the previous example, if you expect total annual loan payments of $50,000, your after-tax cash flow would be $110,000 minus $50,000 minus $12,000, which equals $48,000.

Knowing the effects of depreciation can help you determine whether an apartment building will generate enough cash flow to meet your investment objective. For example, if you need an investment property to generate at least $45,000 in annual after-tax cash flow, the benefits of depreciation would help the property from the previous example meet that aspect of your criteria. Without depreciation, your income tax expense in the example would be higher, and your after-tax cash flow would not meet your objective.