Introduction:
What are Depreciation Tax Advantages for Private Real Estate Investors? Find out here.
Depreciation is the gradual loss of an asset’s value caused by expected wear and tear. As a real estate investor who owns income-producing rental property, you can deduct depreciation as a cost on your taxes. That implies you’ll have less taxable income and may owe less tax.
The depreciation deduction is allowable for the whole estimated life of a property. For example, suppose you buy a house to rent it out. The building is worth $300,000 (minus the land it sits on). If you divide that amount by the dwelling’s estimated life of 27.5 years, you can deduct $10,909 in depreciation per year.
However, after you sell, you must pay the regular income tax rate on the depreciation you claimed. This is famously known as depreciation recapture, which you may avoid if you use alternative tax methods, such as a 1031 exchange (more on that below).
Ask your accountant about depreciating large upgrades to your rental properties, such as adding a new roof.
One of the most excellent advantages of investing in private real estate is the numerous tax advantages. Among them is the ability to deduct depreciation, a tax benefit that can only be used on investment properties. It enables owners to significantly reduce, if not eliminate, taxable income on rental profits.
However, the rules on depreciation, like much of the tax code, can be complicated. They provide many options, so investors must be able to determine which ones will allow them to maximize this tax benefit. We evaluate each property individually. Here are the fundamentals we assume for our properties to maximize the tax benefits offered by the depreciation deduction to investors.
What is the definition of depreciation in private real estate?
Unlike the traditional cliché about new cars, which lose 30% of their value when you drive them off the lot, depreciation works for investors rather than against them in rental properties. Depreciation in real estate is the decrease in a property’s value caused by age, wear and tear, or decay throughout its useful lifespan. When paying taxes, the United States tax code allows private real estate investors to deduct the capital spent on a property to maintain it, even if the property generates positive cash flow.
To depreciate private real estate, however, numerous conditions must be met. An investor must own it to create income, intend to keep it for more than a year and be able to calculate the property’s useful life, which is the lifespan mandated by the IRS code. The IRS permits investors to deduct depreciation on a residential rental property for 27.5 years and commercial property for 39 years.
The amount of depreciation an investor can deduct each year is determined by three factors:
● The property’s cost basis is how much the investor paid.
● The useful life of the property (as described above).
● The method of depreciation is utilized.
However, the cost basis is merely the starting point for computing depreciation; understanding the depreciable and modified cost bases is also required. Remember the following:
The cost basis covers everything spent to acquire and put a property in service. The basis includes the mortgage debt received to purchase the property, all legal charges, debt accepted from the main seller, and fees for reports, long surveys, transfer taxes, title insurance, and so on—any capital improvements after the purchase of the property increase the property’s overall basis. For example, suppose we acquire a home for $1 million and invest an extra $200,000 in capital upgrades; the property’s cost basis is $1.2 million.
Because it removes a property’s land cost, a depreciable basis is utilized to compute the annual depreciation deduction. The land is not a depreciable asset under the IRS Code because it is never depleted. Hence it must be deducted from the purchase price of a property. Assume that land costs $100,000 in our previous scenario. The evident basis is $1.1 million (the cost basis of $1.2 million less than land cost).
Another metric to keep track of when calculating depreciation is the adjusted cost basis. It considers events that occur over time to increase or decrease the cost basis of a property, such as capital upgrades or normal wear and tear. The flexible basis is computed by taking the property’s cost basis, adding improvement costs and related charges, and removing depreciation or depletion deductions. This amount calculates the capital gain or loss when a property is sold. Assume the depreciation deductions in the above example total $40,000 since inception. The modified cost basis would be $1,160,000 (the $1.2 million minus the $40,000 depreciation savings).
The technique that investors can use to calculate their depreciation deductions is determined by the Internal Revenue Service’s Modified Accelerated Cost Recovery System and is based on the life of the item being depreciated (MACRS). Under these standards, buildings are normally depreciated on straight-line depreciation over 27.5 or 39 years, whether the property is primarily residential or purely commercial. Straight-line depreciation distributes the property’s value evenly over its useful life.
Depreciation can result in significant tax savings. It immediately decreases an entity’s taxable income, resulting in lower taxes and greater after-tax cash flow. This is known as depreciation expenditure or the amount of a fixed asset consumed as an expense.
Here’s an illustration of how it works. Assume an investor pays $1,000,000 for a residential rental property. If the property is worth $175,000 and the structure costs $825,000, the annual depreciation is $30,000 ($825,000/27.5). In this example, let’s say the property generates a 5% cash return, which equals $50,000. Unlike stock dividends, which are completely taxed in the year of receipt, rental income is significantly sheltered from taxation through depreciation, offering the genuine potential for investors to enjoy a highly tax-efficient income stream for years, as shown in Table 1.
Table 1 of How Annual Savings from Depreciation Works
Cash From Rental Operations
$50,000
Less: Deprecation
($30,000)
Taxable Income
$20,000
Tax @ 37%
$7,400
Post-Tax Cash Flow
$42,600
Annual Tax Savings ($30,000 x 37%)
$11,100
In the preceding example, we analyzed depreciation on a structure with a tax life of 27.5 years. MACRS provides detailed guidance to compute the correct depreciation expense for a given year for assets with a life of 20 years or less, including accelerated depreciation for certain capital improvements such as landscaping, fences, walkways, and so on.
Furthermore, recent tax code revisions allow for “bonus depreciation” on qualified property in the year it is in service, allowing investors to deduct any applicable big capital expenditures all at once. Bonus depreciation can give significant tax savings and be utilized for property upgrades related to rentals, such as landscaping and pricey fixtures and appliances.
How does depreciation affect property sales?
While depreciation benefits investors when they possess property, it is detrimental when they sell it. This is because depreciation reduces the property’s cost basis, resulting in bigger gains when the property is sold. These gains are taxable and subject to depreciation recapture, which permits the IRS to collect taxes on deductions previously used to offset taxable income by the property owner.
Depreciation recapture is assessed when a depreciated property is sold, and the sale price exceeds the adjusted cost basis. In other words, when the sale results in a taxable gain. The tax treatment of depreciation recapture might be either ordinary income or capital gains, depending on whether the property was sold under Section 1245 or Section 1250. Section 1245 property comprises physical personal property. Section 1250 property is typically depreciable real estate like residential rental buildings.
When a section 1250 property is marketed for a profit, the profit is taxed at a maximum rate of 25%. In tax accounting, this is known as unrecaptured section 1250 gains. The 25 percent cap on the recapture rate is a silver lining for investors in a high tax bracket, as they are likely to have benefited from depreciation deductions throughout the waiting period at their typical income tax rates, which can be as intense as 37 percent.
Here’s an illustration of how this works. Assume an investor sells the asset after ten years for $2,000,000. Remember that the investor claimed $30,000 in annual depreciation using the straight-line technique. The taxable gain on the sale is placed into two tax categories in this case: unrecaptured section 1250 gains, which are taxed at 25%, and section 1231 gains, which are taxed at the preferential long-term capital gains rate, which changes depending on an investor’s tax rate.
Table 2 shows how this works when a property is sold. The depreciation recapture illustrated below is subject to a 25% tax rate. However, the investor deducted depreciation at 37% per year throughout the 10-year hold period. As a result, the investor has saved $36,000 in net taxes.
Table 2 of How Depreciation is Done at Sale
Original Cost of Property
$1,000,000
Amount of Depreciation Deductions From Years 1 to 10
($300,000)
Adjusted Basis
$700,000
Amount of Sale Price
$2,000,000
Amount of Adjusted Basis
($700,000)
Amount of Taxable Gain on Sale
Categorized as Below
$1,300,000
Amount of Unrecaptured Section 1250 (Taxed at 25%)
$300,000
Section 1231 gains (Taxed at Long Term Capital Gains Rate)
$1,000,000
Table 2 depicts the effect of depreciation recapture when real property (section 1250 property) is depreciated straight-line. While this is the usual scenario, tangible personal property (section 1245 property) depreciation can affect the equation. The gain on the sale of tangible personal property will be taxed as ordinary income, not capital gains, to the extent of any depreciation (including bonus depreciation and section 179 depreciation, which is normally limited to tangible personal property utilized for business). This is referred to as Section 1245 recapture.
Table 3 – Overall Tax Savings from Deprecation
Straight Line Depreciation During Hold Period: Years 1 to 10
$300,000
Tax Savings on Above (37% of $300,000)
$111,000
Recapture Tax Paid at Sale (25% on $300,000)
($75,000)*
Net Savings in Taxes from Depreciation
$36,000
*Assumes the investment is in the top federal tax bracket.
How do you decide which depreciation deductions to claim?
One thing is evident from these examples: it is advantageous to be aware of the tax implications of depreciation over the life of the property and the effects of depreciation recapture at the time of sale. Investors must decide which depreciation technique to adopt to get the benefits of each. For example, the distinction between straight-line and accelerated depreciation demonstrates that certain components of a rental property business, such as eligible capital upgrades, might depreciate faster, potentially resulting in significant upfront tax savings.
However, investors who employ such accelerated depreciation procedures must consider the tax implications for the business interest deduction—a deduction for the interest cost on any loans required to continue a corporation’s operations or pay its expenditures.
Investors may find all of these alternatives confusing. We evaluate each property we acquire to determine which methods of depreciation provide the greatest advantage to our investors. Because our properties are held in funds to decrease risk and maximize returns, we consider the assets’ hold length, tax rates, overall profits earned from other assets of ours, fund structure, and the impact of acceleration on interest deductibility.
While depreciation is one of the most beneficial tax perks of real estate investing, investors may still face a hefty tax bill when selling a property, especially if they have depreciated it for years. Effective tax planning tools, such as Qualified Opportunity Zone investments, can enable investors to defer and protect tax payments on capital gains and unrecaptured section 1250 income for a long time.
Please check with your tax expert for the most up-to-date information on the various tax repercussions of real estate investment. We are here to help you in the best way possible.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.