Investing in real estate can provide important tax benefits. One of the most significant is the ability to depreciate the value of the investment over time to reduce tax obligations on income generated by the property. In some cases, income can be fully sheltered from taxes.
In this blog article, we’ll present an overview of how investors can take advantage of real estate depreciation rules and minimize the tax bite on ongoing income as well as at time of sale.
What is Depreciation?
In general, investors are allowed to deduct the cost of purchased assets against their income in two ways. Items having a short-term useful life such as supplies or repairs are expensed and fully deducted against income in the year they were put into service. The cost of assets with a useful life greater than one year or more are typically proportionately deducted or depreciated over their full useful life.
What is the Depreciation Process for Rental Properties?
Per IRS guidelines, real estate investors are permitted to deduct a portion of a building’s value against income over a designated useful life. This is permitted even if the property is not substantially deteriorating or being used-up as it ages. Only the building value can be depreciated – not the land which is regarded as having an infinite useful life.
Different types of real estate assets have different allowed depreciation schedules. Residential real estate such as single-family rentals or apartments can be generally depreciated over 27.5 years while commercial assets such as office buildings or retail properties are normally depreciated over 39 years.
The determination of the depreciable portion of a real estate investment should be done by a qualified third party such an appraiser or a tax assessor.
Impact of Depreciation on Cost Basis
The initial cost basis for rental real estate is your acquisition cost (including any mortgage debt you obtained plus miscellaneous acquisition related fees) minus the value of the land it's built on.
If you invested $500,000 in a rental property and the land is appraised for $100,000, your beginning cost basis would be $400,000.
For tax purposes, the original cost basis is adjusted over time by 1) reducing the original basis by the amount of allowed depreciation 2) increasing the basis by the value of improvements made to the property. The new basis is referred to as “adjusted basis.”
Back to our previous example, if, after purchasing the property, you invested an additional $50,000 to add a new roof, your adjusted cost basis for depreciation purposes would be $400,000 of original basis plus $50,000 in improvements or $450,000.
Why Depreciation Is a Huge Advantage for Real Estate Investors
Depreciation write-offs can dramatically reduce income tax obligations through providing an annual tax deduction that isn’t really an expense. A well-maintained building will not be fully used up and or become worthless at the end of its government mandated useful life – yet, thankfully, the IRS allows real estate investors to offset taxable income with this faulty presumption.
Therefore, income from rental properties generally has a lower effective tax rate than virtually any other type of income. In fact, depreciation along with other allowed deductions may result in rental properties showing a loss for tax purposes, even though they are profitable.
Is it Possible to Increase Depreciation Deductions?
Yes. As powerful as standard depreciation deductions can be, there are several legitimate techniques that can further reduce taxable income. A common technique is to analyze the components of a building and depreciate items having a shorter useful life separately from items that conform to the standard overall useful life of the building. For example, the IRS allow investors to depreciate appliances over a useful life of 5 years. Terms used for this approach are “component depreciation” or “cost segregation.”
This is not a “do-it-yourself” process and generally requires a knowledgeable third party to review the design of the building and complete a formal “cost study” to highlight those components that may be eligible for accelerated depreciation – or even immediate expensing i.e., writing off the full value of the item in the first year of service rather depreciating it over time – all of which can increase depreciation deductions and reduce taxes.
Some sponsors of Delaware Statutory Trust (DST) investments provide cost segregation studies to investors. If such studies are not available, DST investors may still be able to obtain one at a nominal fee.
Component depreciation can be a complex area to navigate that will require the services of a qualified real estate tax advisor and appraiser and many investors may be satisfied by using the simpler straight-line useful life guidelines allowed by the IRS.
Depreciation can be a two-edged sword – it’s nice to have it when you are owning your property, but it can become a huge challenge to overcome when selling it. Why?
As previously discussed, depreciation reduces the taxable basis of an investment property over time. If we paid $500,000 for a rental and deducted $200,000 in depreciation write-offs over the holding period of the investment, the adjusted tax basis would drop to $300,000 (presuming no capital investments were made).
If we then sold the property for $1,000,000, our taxable gain would be $1,000,000 less the adjusted basis of $300,000 or $700,000 – and not the $500,000 between what we originally paid and eventually sold it for.
Not only would an investor have potential tax liability on the $700,000 capital gain, but the IRS would also require that they pay a 25% additional tax on all the depreciation that was taken (or could have been taken). Depreciation recapture is arguably one of the harshest taxes to be paid at time of sale and, combined with capital gains and other taxes, can easily result in a combined tax liability equal to 35-40% of the gains. Ouch!
Very fortunately, real estate investors can potentially fully defer all these taxes by successfully completing a 1031 exchange. We’ll spare you the details of how a 1031 exchange works in this blog and instead refer to other written materials on our www.FGG1031.com website where you can also download my popular book entitled Real Estate Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST) to learn about 1031 exchanges.
The availability of depreciation deductions helps to make investing in rental properties more attractive than investing in other types of assets resulting in greater after-tax income for comparable pre-tax returns.
This blog is intended to only provide an overview of basic concepts of how to take advantage of depreciation and, as you may now better understand, the topic can quickly get complex.
As always, we recommend that you seek inputs from qualified real estate tax advisors when considering depreciation strategies.
Please contact us for more general information on real estate tax strategies and also for referrals to knowledgeable tax professional via phone at 408 392-8822 or via email at info@FGG1031.com.
2 Fees for cost studies on DSTs ranging from $500 to $1,200. have been quoted to our firm.