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  5. Depreciation


Depreciation can be described as the decrease in value that an asset experiences over time due to age, wear and tear, or unfavorable market conditions. Depreciation is used in accounting to reflect the percentage of an asset that was used during a period based on the anticipated useful life of the asset with normal use. The IRS has set forth guidelines that indicate the percentage of Depreciation allowable to claim as an expense every year for each class of asset. The original basis of the asset is multiplied by the percentage to calculate the amount of Depreciation to expense every year that the asset is held by a qualified owner. The actual life of a building may be longer than the allowable Depreciable life. Congress has established this policy to encourage investment and reinvestment of net cash income. Since Depreciation is a non-cash expense, it often creates differences between the profit margin and net cash income. Applying the Depreciation of a property as an expense will reduce the taxable income of the investment. Accumulated Depreciation is subtracted from the original basis of a property to calculate the current basis of a property. A lower basis increases the taxable income on the sale of the property. If a portion of the cash windfall created by Depreciation has been saved, money available for capital improvements can be spent on the property to restore its basis to the original value. Depreciation is a key attribute that many knowledgeable investors identify as motivation to invest in real estate versus other forms of capital investment.

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