How does adding depreciation increases rental income?

[jyeh74]

I thought rental income = rents - expenses

Depreciation is considered an expense.  So wouldn't adding depreciation reduce your rental income according to the formula above?  A loan person says adding depreciation actually increases your rental income.  I don't understand.

So I forgot to add depreciation and proceeded to amend my taxes.

On schedule E (original taxes without depreciation added), line 24 "income" is $20,000.  On schedule E (amended taxes after adding back depreciation), line 24 "income" is now $100.  

However, on schedule E, line 25 "losses" went from -$17,000 to -$5000.  Adding depreciation reduced my loss.

But line 26 "total rental real estate income/loss" is the same number.

So it looks like my rental income reduced to $100 from $20,000 after adding back depreciation.  Why is it that loan officers say when you add back depreciation, your rental income increases?

[Anita01 · Accepted solution]

Loan officers are often not the best at explaining taxes.  You don't actually increase your taxable income through depreciation.  What happens is you get to deduct an expense that doesn't really cost you any money during the year, so your taxable income from the rental decreases and you pay less tax on your rental income.

Line 24 of your Schedule E makes perfect sense.

Line 25 is not actually your real loss, it's your deductible loss.   With real estate, losses up to $25,000 are deductible if your OTHER income is less than $100,000.  Did you add any additional income when you amended?

[jyeh74]

@TurboTaxAnita so by adding back depreciation, did my rental income actually decrease from $20k to $100?  So I got less rental income?

[Anita01]

You got less taxable income.  There's really a big difference between income and taxable income.  If you receive $1,000 in rental income, the only taxable part if the amount is after your expenses.  Since depreciation is an accounting adjustment to income but does not cost you cash like your other operating expenses, you get to keep more of that income without paying tax on it.  That's a major reason people love having rental income.

Unfortunately, you do have to pay tax on that depreciation if and and when you sell the property at a gain.  Your taxable gain is the difference between your cost and your sale price.  Cost is lowered by the amount of depreciation taken over the years, so your taxable gain becomes larger when you sell.  You really do need to take depreciation, though, because, when you sell, you get taxed on any depreciation you took, or COULD HAVE TAKEN.  so, you pay tax on the total depreciation whether you took it or not.  You are always best off to lower your taxable income each year by the depreciation amount.

Depreciation is a difficult concept, but it will become clearer the longer you own your rental

[jyeh74]

@TurboTaxAnita the loan officers must be using a different formula than what I see on the schedule E.  Loan officer said adding depreciation actually makes you look like you have more rental income.  Hard to visualize that statement when looking at schedule E.

[Anita01]

That would be an incorrect comment for anyone to make, as it's mathematically impossible to claim more expense and show more income.  Loan officer was not using a correct formula or simply does not understand depreciation.

[Anita01]

He may be trying to increase your spendable income by lowering your taxable real estate income, and is just not doing a good job of explaining this to you.

[mvk_atl]

The loan officer is likely talking about how, in deciding what your actual vs your taxable income was for purposes of a loan, they add back the depreciation to see what your cash flow from the rental was.