Introduction:
Want to know more about real estate depreciation on multi-family properties? I got you covered. Read this article to learn more!
Investing in Multifamily Apartments
Real estate can be a viable alternative for people who cannot tolerate the volatility of the stock market. It is also a superior investment for investors who want to actively manage their wealth rather than passively investing in a fund managed by someone else. One of the wonderful aspects of real estate investing is that multiple strategies can be employed successfully.
For example, Donald Bren and Zhang Xin established billion-dollar fortunes in real estate investing by developing numerous residential and commercial properties. On the other hand, residential equity founder Sam Zell amassed his fortune gradually by amassing an income-producing portfolio of rental properties.
Other real estate speculators have made millions of dollars by flipping houses or buying run-down properties for pennies on the dollar and refurbishing them before selling them to new owners.
Property depreciation shields your financial gains from annual tax expenses on real estate investment assets. This can result in significant annual expense savings for you. If you sell a property without exchanging it, you may be obliged to refund this sum on a future year’s tax report, but you will most likely owe a lower tax assessment at that time.
This tax deferral owing to depreciation allows you to postpone some tax payments until later as a property owner or passive participant in syndication investment projects. This can result in extra “after-tax” funds in your pocket for the current year.
For investors seeking an additional source of monthly income and a slow but steady increase in the value of their portfolio, rental property investing is the favored investment method. There are two residential real estate properties in which one can invest: single-family and multi-family.
As the name implies, single-family properties are residential buildings with only one accessible rental unit. In contrast, multi-family properties, usually known as apartment complexes, are buildings with more than one rentable space. While developing a portfolio of tiny homes has lower entrance hurdles, investing in large residential complexes has various advantages. Here are three reasons to consider investing in multi-family real estate rather than single-family rental properties.
Are you in a financial position where property management makes sense? Some real estate investors dislike property management and instead hire a property management company to handle the day-to-day operations of their rentals. A property manager is often paid a percentage of the monthly income generated by the property, and their responsibilities may include locating and screening tenants, collecting rent payments, resolving evictions, and maintaining the property.
Many investors who possess one or two single-family homes do not have the luxury of hiring an outside manager since it would not be a financially smart move given the size of their portfolio. The money that multi-family properties generate each month allows their owners to benefit from property management services without drastically reducing their margins.
What Is Depreciation & How Does It Help Property Owners?
Depreciation is a drop in value caused by wear and tear, degradation, or a price fall. Depreciation permits property owners and investors to write off a tax loss for the current tax payment year. The contrast between business costs and capital expenses is well-known among investors and property owners who focus on their annual tax returns.
Suppose you own a big multi-family apartment building or are a passive investor in this property through a real estate investing (REI) syndication. In that case, you know that plumbing renovations can be deducted as an item of business expenditure. Installing new roofing or external building siding, on the other hand, is a capital expense.
This capital expense must be depreciated over several years (for example, 27.5 years). The property requires constant care because its value does not often drop over time. As a result, property owners and investors are eligible for a tax deduction for property depreciation.
Which of the following examples is depreciable?
The IRS states that you can depreciate the property if it meets all of the following criteria:
- You own the land (you have considered the owner even if the property is related to debt).
- You use the property in your business plan or as a source of income.
- The property has a determinable useful life, which means it wears out, decays, is used up, becomes obsolete, or loses value due to natural causes.
- The property should survive for at least a year.
- Even if the property fits all of the above criteria, it cannot be depreciated if it is put into operation and then disposed of (or no longer used for business purposes) in the same year.
The land is not deemed depreciable because it is never “used up.” In general, the costs of clearing, planting, and landscaping cannot be depreciated because they are considered part of the cost of the land rather than the buildings.
When Does Depreciation Commence?
You can take depreciation deductions as soon as you put the property into service or when it’s ready to rent.
Here’s an illustration: On May 15, you purchased a rental property. You’ve been working on the house for several months, and it’s finally ready to rent on July 15, so you start advertising online and in the local newspaper. You find a tenant, and the lease starts on September 1. Because the property was placed in service—that is, ready to be leased and occupied—on July 15, you would begin depreciating it in July rather than September when you begin collecting rent.
- You can depreciate the property until one of the following requirements is met:
- You have deducted the total cost of the property.
- You deactivate the property even if you have not fully recovered its cost or another basis. When you no longer utilize the property as an income-producing property—or if you sell or trade it, convert it to personal use, abandon it, or destroy it—it is retired from service.
- You can continue to deduct depreciation on property that is temporarily “idle” or not in use. If you perform repairs after one renter leaves, you might continue to depreciate the property while preparing it for the next tenant.
The amount of depreciation you can deduct each year is determined by three factors: your basis in the property, the recovery period, and the depreciation method employed.
Any residential property placed in service after 1986 is depreciated using the MACRS, an accounting technique that stretches expenditures (and depreciation deductions) over 27.5 years. This is when the IRS considers a rental property’s “useful life.”
Depreciation reduces tax liability by how much?
When you file your annual tax return, you normally enter your rental income and expenses for each rental property on the relevant line of Schedule E. The net gain or loss is subsequently reported on your 1040 tax return. Because depreciation is one of the expenses listed on Schedule E, the amount depreciated effectively reduces your tax burden for the year.
If you depreciate $3,599.64 and are in the 22 percent tax rate, you will save $791.92 in taxes that year ($3,599.64 x 0.22).
Depreciation can be helpful if you invest in rental properties because it allows you to spread out the expense of purchasing the property over decades, lowering your tax payment each year. However, if you depreciate property and subsequently sell it for more than its depreciated worth, the depreciation recapture tax will apply to the gain.
Because rental property tax regulations are complex and change regularly, you should always consult with an experienced tax professional when starting, maintaining, and selling your rental property business. That way, you can be certain of receiving the most favorable tax treatment and avoiding unpleasant surprises at tax time.
Why Can’t You Depreciate All of Your Real Estate?
The land is an infinite asset that does not deteriorate with time. You might have put $1 million into a large multi-family building. However, you cannot depreciate this full price at tax time because the land on which the complex is built is not depreciable.
It would help to estimate the property value percentage allotted for upgrades to get the best tax break. Then double this figure by the value of your first purchase (or investment). The resulting amount can then be depreciated over multiple tax years. For instance, if your percentage is 75%, you can depreciate 75% of $1 million, or $750,000, during the remaining depreciable life of your investment property.
How to Calculate Property Depreciation in Percentages
Your accountant or tax professional can calculate the depreciation percentage on your investment property. These financial professionals frequently utilize a reasonable estimate of this value. However, it would be best if you did not base your estimate on your property tax bill.
The assessor’s office associates =the amount of the percentage tax you are charged on the property valuation. Thus you cannot use your tax bill to calculate this estimate. They are unconcerned about which percentage is designated for upgrades and which represents the land.
Large Multi-family Property Depreciable Life
Large multi-family apartment complexes with up to 3,000 units depreciate over 27.5 years. Suppose you invest $1 million in a large multi-family property. In that case, you can claim a legitimate property depreciation tax deduction of $1 million multiplied by 75% ($750,000) divided by 27.5, which equals $27,273 yearly for the following 27.5 years.
If you are a limited partner in a $500,000 syndication multi-family property investment, the annual depreciation charge is $18,182 ($500,000 divided by 27.5). If this multi-unit property earns $80,000 in annual income, your tax bill will be as follows:
Taxes Due Prior to Depreciation: $80,000 x 25% (federal income tax) = $20,000
After-Depreciation Taxes: ($80,000 – $18,182) x 25% = $15,455
As a passive investor, these calculations enable you to save $4,545 every tax year before further gains from adding other allowed deductions.
Accelerated Depreciation for Immediate Tax Savings
Different asset improvements depreciate at different rates. For example, if you remodel your large multi-family investment property with ensuite bathtubs for the master suites in each unit, you can deduct these renovations over 27.5 years. However, new carpets, window blinds, or appliances placed in each flat can depreciate over five years. These restrictions allow you to obtain significant tax savings sooner.
The Importance of Understanding Depreciation Fundamentals
Depreciation savings account for a significant amount of a successful real estate investor’s after-tax income. As a result, it is critical for every investor in multi-family properties to understand the fundamentals of property depreciation.
As a passive investor, you can develop your earnings more quickly and steadily by getting after-tax funds for future investment by making smart and effective use of depreciation.
More on the Real Estate Depreciation Tax
Depreciation is regarded as one of the most valuable tax shelters by most experienced passive investors (limited partners) in syndication multi-family property investments. Depreciation is founded on the idea that all property depreciates over time. Depreciation is a legal tax deduction that accounts for a property’s wear and tears, or fatigue, as time passes.
Fresh investors in multi-unit apartment buildings or complexes frequently ask how a property depreciates or drops over time as its market value rises. According to the IRS, the quality of a property as an asset deteriorates over time.
However, if a property is well kept and located in a dynamic, rising area, its value will rise. As a result, the IRS allows the owners (or investors in) this property to deduct a depreciation expense amount from their owing real estate income tax. This is true whether or not the property earns a profit or increases in value.
Additional Advantages of Cost-Segregation
Cost-segregation is analogous to depreciation. The primary distinction is that cost segregation in multi-unit properties incorporates certain variables’ value depreciation. For example, cabinets, appliances, and fixtures have reduced lifespans under IRS standards.
As a result, the IRS allows real estate owners in multi-family residences to deduct depreciation charges for these items over seven years. Suppose you are a passive investor in a syndication property investment for $500,000 with $100,000 in cabinetry, appliances, and fixtures; your depreciation expense will be calculated as follows:
$500,000 – $400,000 in property value
Expense for Property Depreciation = $400,000 / 27.5 = $14,545
Depreciation on cabinets, appliances, and fixtures = $100,000 / 7 = $14,286
Total Depreciation Expense = $14,545 + $14,286 = $28,831
When you compare your property depreciation costs to the cost-segregation, you can see that the cost-segregation gives a greater tax shelter. However, cost segregation usually affects your tax bill when you sell your property. The more you employ cost segregation for tax shelter purposes, the larger your tax burden will be when you sell your property.
Advantages of 1031 Exchange Tax
Real estate investors can trade multi-unit rental buildings with little capital gains tax liabilities and, in some cases, none under IRS Code Section 1031. However, to be eligible for this benefit, investors must meet the following criteria:
- The new property must have an equal or greater worth than the previous item.
- The traded property must be used for productive business activity.
- The two properties must be of a comparable or the same kind.
Advantages of Passive Income Taxation
The IRS considers someone a real estate professional if they spend more than 500 hours on real estate each tax year. However, if you spend less time on REI projects each year, you are not considered a real estate professional for tax purposes. There is a passive income tax benefit for non-real estate professionals who own multi-family properties.
Non-professional real estate investors must pay passive income tax instead of regular income tax. When the value of their investment properties increases, they must pay capital gains taxes. However, the tax rates on passive income and capital gains are often lower than those on federal income. As a result, as a non-professional in real estate, your taxes on multi-family property investments will be much cheaper than those of professionals.
As you can see, you can reap significant tax benefits from your assets by doing your homework and employing sound tax tactics. As a passive investor, you can significantly decrease your tax responsibilities by taking advantage of these appealing and cost-saving perks.
Finally, consider the following:
The IRS’s tax deferral limits for real estate depreciation allow passive property investors in syndication arrangements to postpone some tax responsibilities. This can result in massive cost savings as “after-taxes” funds for you as a passive property investor for the immediate year.
Once you grasp the fundamentals of depreciation and calculate the percentage of depreciation for an investment property, you will be well on reaping considerable tax benefits from your passive REI investments.
As a passive real estate investor, you can reap numerous tax advantages that will help you develop your investment portfolio and increase your profits. You can reap the benefits of being a wise and successful passive investor.
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