Real estate investing is like a unicorn or the Holy Grail.
You can purchase an asset (actually, you can get other people to give you money to purchase an asset) and have someone else pay off the asset for you, all the while taking on tax deductions to seriously reduce any potential income in the eyes of the IRS!
We’ve talked previously about the many tax benefits and tax deductions in real estate investing, but we are going to take a closer look at depreciation and how it is such a great tax advantage!
Depreciation is a tax deduction where you can deduct the costs of an expense related to your business – in our case, our real estate properties. Instead of taking the deduction as a lump sum in the year you purchase the property, depreciation allows you to distribute the deduction over a certain number of years. Best of all, you are in charge of how much of the asset you depreciate each year – meaning you decide how much is written off each year.
For instance, if you had a year with significant expenses resulting in a net loss, you can delay applying the depreciation until the following year.
In order to depreciate an asset, specifically a rental property, the IRS states you must meet the following requirements:
It is important to understand the last two bullets in what qualifies as a depreciable property.
As previously mentioned, depreciation is up to the individual taxpayer, and while typically, the deductions are equally distributed, there is no reason you can’t take the entire lump sum upfront. House flippers who buy and sell properties in the same year could theoretically take advantage of the entire depreciation deduction in the year they purchased the property; however, the IRS stipulates that it cannot be depreciated if it was put into service and disposed of in the same year.
When performing the depreciation calculation, your tax preparer (or yourself if filling your taxes) will need to determine the cost of the land and the cost of the property. Only the property is considered depreciable because there is wear and tear and it gets “used up”. Land, on the other hand, cannot get used up and thus isn’t considered depreciable.
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The moment the property is placed “into service” or rent-ready you are allowed to begin depreciating the property. For instance, if you purchase a property and have it rent-ready on June 1st but it remains vacant until October 1st, depreciation begins on June 1st, not October 1st. The property was placed into service or rent-ready in June.
The property can continue to be depreciated as long as the following remain true:
Even if the property is temporarily idle or not in use, as you are making turnover repairs after one tenant moves out, you can continue to claim depreciation.
Before we dive deep into the math and calculating depreciation it is always recommended that you work with a tax professional to ensure you are correctly taking the deductions.
Now that we have the technicality out of the way, there are three basic considerations when determining how much you can deduct each year:
To determine the basis of the property, we look at the cost or the actual dollar amount paid for the property. It is important to know which settlement fees and closing costs should and should not be included as this will change your basis.
As previously mentioned, the land that the property sits on is not “usable” and therefore should not be included in the basis. To calculate each, we need to separate the cost of land and buildings. To determine the value, you can utilize the most recent base number on the assessed real estate tax values or the fair market value. Using simple math, you can then determine the value of the land and the value of the property.
Let’s say for example the most recent real estate tax assessment value for the property was $125,000. The house had an assessed value of $100,000 and the land value was $25,000. We can then say that the value of the house is 80% ($100,000/$125,000) of the assessed value.
If we purchased the property for $150,000, we can utilize the basis of the property (from our previous example) and apply it to our purchase price. Therefore, using 80% of our basis in the property and applying it to our purchase price of $150,000 we can appropriately depreciate $120,000.
If you have a rental property that was put into service after 1986 it will be depreciated utilizing Modified Accelerated Cost Recovery System (MACRS). Under MARCS, depreciable assets are assigned to a specific class which the IRS has provided guidance on the asset’s useful life.
While the typical MARCS method of General Depreciation System (GDS) is most commonly applied to rental properties, it’s important to know when the law requires use of the Alternative Depreciation System (ADS).
The recovery period is a designated time frame that the IRS allows you to take deductions based on different types of depreciable assets. They range anywhere between three years and up to 50 years. It’s important to understand which asset you are trying to depreciate.
Per the IRS, the applicable recovery period for residential rental properties is 27.5 years if using GDS. However, if using the ADS, the recovery period is 30 years if the property was placed in service after December 31, 2017 and 40 years if it is placed prior to that.
In the event you own a non-residential rental property – office buildings, stores, or warehouses, the useful life is 39 years.
According to the IRS, rental properties typically depreciate at about 3.6% for 27.5 years. Using this percentage, you can get a rough estimate of how much you can depreciate each year.
At some point, you are likely going to sell of your rental property. When this occur, the IRS will require the taxpayer to payback the financial gain earned from the sale of the property. This process is called: depreciation recapture.
Depreciation recapture I simply a fancy term which allows the IRS to “recapture” some of the tax deductions we had previously taken as part of the “depreciation”. While you save money on taxes through depreciation, the IRS recoups some of that at time of selling the property. This is because the gains realized from sale of a property are calculated by determining the difference of the asset at its lowered depreciation-adjust cost basis from the total sales price.
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One method to help minimize the tax burden at time of sale of property and avoid both depreciation recapture and capital gains taxes, is to perform a 1031 exchange.
In simplest terms, a 1031 exchange allows an investor to avoid capital gains tax but utilizing the proceeds of a sale to acquire a property that is similar in nature to the one sold. This technique allows the investor to acquire properties of equal or greater value which can help you strengthen your real estate portfolio!
Rental properties produce income and expenses which are reported on Schedule E when you file your annual tax return. After determining the net gain or loss, this is transferred to your 1040 form. Since depreciation is reported as a rental expense it is also reported on Schedule E which can reduce your tax liability for the year.
Utilizing tax strategies such as depreciation can provide monumental tax savings if performed correctly. They can reduce the net gain reported to your 1040 subsequently reducing your taxable income. Additionally, it can be spread out the cost of purchasing the property over decades which can provide tax savings year after year!
Due to the periodic changes and complicated natures of rental tax laws it is always advised to work with a qualified tax professional. We aimed to provide an introduction into what depreciation is and why it is essential to take advantage of this tax saving strategy!