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Depreciation is Real: Strategizing Remodels and New Construction

When most people speak about depreciation and real estate, they talk about the tax benefits. Often, you will hear a new real estate investor or some real estate guru say, “You can earn cash flow tax-free because in real estate there is depreciation!”

The problem with this statement is that depreciation is very real and tax benefits are given to allow property owners to consistently invest in aging real property, like a new roof, updated plumbing, or new electrical systems.

Depreciation Rules

For commercial property, the life and deprecation schedule granted by the IRS is 39 years. Have you ever seen a commercial property that has not been upgraded in 39 years? It is about as useless as a dirt lot. Years of deferred maintenance will produce a property that needs heavy investment, thus affecting its resale value.

For residential rental real estate, the life and depreciation schedule granted by the IRS is 27.5 years. This is for residential rental real estate only (4 units or less). A primary residence will not realize depreciation from the IRS, but you better believe your home’s structure is going to incur depreciation.

Think of Your Home as a Car

Think of your home as a car if maintenance was done, but no upgrades…

1st Tier: Brand New Car = New Construction Home

2nd Tier: Pre-Owned Certified Car = Mid 2000s Construction Home

3rd Tier: Old Used Car (that runs) = Late Century Homes (70s, 80s, 90s)

4th Tier: Junk Car/Scrap = Mid Century Tear-Downs

This is not a perfect example, but if you can think of homes without upgrades in this manner, you will have a good understanding of depreciation.

If you track the real estate market, new construction homes always get the highest premium relative to comparable home sales, much like a new car. Once a house ages past five years or the style has fallen out of trend, it begins selling at a discount to new construction, much like a pre-owned certified car would. But don’t forget, the depreciation is not the same as cars because these homes sit on land which has an inherent economic value.

Then, you’ll see the progression of an 80’s home selling as a fixer. Those sell at an even greater discount to mid-2000s construction much like a 15-year old car with 120,000 miles will sell at a discount to pre-owned certified cars.

Lastly, there are tear-down homes, which have depreciated fully and trade at land value, much like a junk car, which will sell for next to nothing.

Real Estate Strategy Buying Strategy

Staying for five years or less…

As an investor at heart, who is always looking for value-add on behalf of clients, I rarely recommend new construction if you are focused on a home as an investment. However, real estate is not always black and white, and if you can afford it, new construction is nice to have, much like a new car.

I will endorse a 1st Tier new construction purchase if you plan to stay in a home for less than five years. Normally, sales of newer construction sell at a small discount to new construction if the style is still on trend. And, if the real estate market is stable, you can normally expect to get your money back, and a strong market will allow you to make a decent profit.

The mistake I most often see is buying new construction to hold 10 plus years, because a 1st Tier home transitions into a 2nd Tier home.

Staying for five to 10 years…

To me, the best strategy in this case is to buy a mid-century home and remodel it. These homes are 3rd Tier and come at a great price. When the remodel is complete, you can get value between a 1st and 2nd Tier home.

If you are not a fan of remodeling, then you need to go with a 2nd Tier home. It will likely be in great condition and extremely livable, just not in the present-day style that warrants top dollar. You will purchase the home at a discount to new construction most definitely, and after 10 years you will have options. Depending on the market, you can decide to sell as-is or update your discounted purchase to get 1st Tier value.

Staying for 10 or more years…

Here is where the biggest mistake is made as result of the new construction fallacy.

Too often, clients want to buy new construction because they think it will always hold its value. Just 15 years ago in 2003, Mediterranean and earth tones were all the rage. Those homes now sell at a major discount. Will white plantation and the modern farmhouse go in that direction in 15 years? It might.

If you must have new construction (and you have time and money), this is where you should consider a 4th Tier tear-down home and build yourself.

You will pay slightly above land value to beat developers and you will spend more to build as well. But if you have the right real estate advisers, you should come out with equity and a home significantly cheaper than buying new construction.

If construction is not your thing, and you plan to stay for more than 10 years, then you should go 2nd Tier. Enjoy the home for 10 to 15 years. At that point, you can choose to sell or do a remodel to earn top dollar.

Conclusion

It is hard to give these examples as nothing is steadfast. Home depreciation is real, and it will affect your purchase and resale price in a big way. Purchasing 1st Tier new construction or buying a 2nd Tier home with intent to remodel down the road will have different and significant impacts on your profit.

Be sure to thoroughly consider condition, time, and your willingness to update or not. These are important factors that deserve thoughtful consideration to earn the maximum return on your home purchase.