WHAT
IS LEVERAGE?
Leverage
is the use of borrowed money to
increase your profits in an investment.
Building wealth via real estate
requires the use of leverage.
Let's assume an investor has $1,000,000
to invest and you purchase a small
income property. Assume that income
properties have been appreciating
at an average of 7% per year.
At the end of the first year,
the property is worth $1,070.000.
At the end of year two, it is
worth $1,144,900. Now let's assume
that you put your $1,000,000 down
on a $5,000,000 income property.
At the end of the first year,
it is worth $5,350,000. At the
end of the second year, it is
worth $5,724,500. By borrowing
money to purchase a larger income
property, you have increased your
borrowing money to purchase a
larger income property, you have
increased your profit by $579,600
in just two years. To get the
full advantage of leverage, put
the minimum down on a good property
which has a strong likelihood
of appreciating in value. Stay
away from questionable property
in demographically challenged
areas.
Depreciation:
Depreciation
is the loss in value of an asset
/ building over time due to
wear and tear, physical deterioration
and age. The cost of reproducing
an income property can be recovered
over the useful life of the
asset which is determined by
law. Only the building can be
depreciated and not the land.
Residential income property
must be depreciated over a 27.5
year period using straight line
depreciation. Commercial income
property must be depreciated
over 39 years using straight
line depreciation.
Straight line depreciation stipulates
that an asset must be depreciated
by equal amounts each year over
its useful life.
Example:
You purchase a warehouse for
$900,000. The land where the
warehouse resides is valued
at $120,000. The building is
valued at $780,000. Current
law allows you to depreciate
commercial properties by equal
amounts annually over 39 years.
Your depreciation deduction
for the first year is based
on the mid month convention.
The day of the month that you
purchase the property doesn't
matter.
You can only deduct half of
the first month's depreciation.
If you put the warehouse into
service on June 1, you are allowed
to deduct 6 and 1/2 months of
depreciation for the first year.
|
$780,000
|
|
| ---------------- |
=
$20,000 |
|
39
|
|
|
$20,000 |
|
First Year Depreciation
= 6.5 X |
(
--------- ) = $10,833 |
|
12 |
Accountants
calculate a full year of depreciation
for the above warehouse (commercial
properties) by multiplying 2.56
% times $780,000 which equals
$19,968. A full year of depreciation
for residential income properties
would be calculated by multiplying
3.64 % times the building basis.
The
depreciation deductions that
you write-off in any year reduce
you taxable income thus increasing
your profit for that year.
Capital
improvements are subject to
the same depreciation laws.
Capital improvements include
the following: a new roof, a
new furnace, an addition to
a building, siding, etc.
Example:
You have owned the above warehouse
for about 7 years now and it
is in need of a new roof. The
cost of the new roof is $19,500.
You are allowed to depreciate
the cost of the roof over 39
years. If you put the new roof
on in July, you are allowed
to deduct 5 and 1/2 months of
depreciation in the first year.
Accountants
would calculate a full year
of depreciation for the roof
by multiplying
2.56 % times $19,500 which equal
$499.
All depreciation amounts that
you write-off in each year for
the building and capital improvements
reduce your adjusted basis for
the property thus increasing
the taxable profit you must
declare when you sell.
|
$19,500
|
|
|
---------
|
=
$500 |
|
39
|
|
| |
$500
|
| First
Year Depreciation (roof)
= 5.5 X |
(
----- ) = $229 |
| |
12
|
Accountants
would calculate a full year
of depreciation for the roof
by multiplying
2.56 % times $19,500 which equal
$499.
All depreciation amounts that
you write-off in each year for
the building and capital improvements
reduce your adjusted basis for
the property thus increasing
the taxable profit you must
declare when you sell.
|
