Real estate depreciation tax deduction

Real Estate Depreciation: What it Means for Investors

Posted by Grant Cardone

The tax benefits of real estate let you keep more of your money at tax time. Find out how to take advantage of one of real estate’s great tax advantages.

You might be wondering how depreciation could be a good thing for real estate investors. After all, when we talk about something depreciating, we usually mean that it’s losing value with time and use.

But for tax purposes, depreciation means something slightly different. It refers to an accounting method that can be very beneficial for investors, if used properly.

It’s also a tax benefit that’s unique to real estate.

As a real estate investor, it’s important to have a basic understanding of depreciation and how it affects your business.

In this guide, we’ll go over the basics of what it is, how it works, and why depreciation is beneficial, especially for real estate investors.

What is Depreciation?

Depreciation is a method of spreading out the cost of a tangible asset, like real estate, over the course of the asset’s “useful life.”.

The “useful life” of an asset, whether it’s a building or a water heater, refers to how long something is productive. It’s the length of time the asset is productive, after which it is no longer considered to be cost-effective. This measurement of time varies depending on the type of asset.

The IRS acknowledges that buildings and equipment lose value over the course of their useful lifespan.

To account for this slow decline in value, tax laws allow property owners to take deductions that offset their original value.

When investors buy a property, instead of deducting the entire purchase price in the first year, depreciation allows them to stretch out the deductions over the course of decades. This means that instead of one huge tax break, they get smaller tax breaks, but for a much longer period of time.

Important to note:

These deductions are for structures, not for land. The IRS doesn’t consider land to be a depreciable asset, reasoning that it doesn’t deteriorate and/or lose value.

There are some requirements that must be met for depreciating real estate:

  1. Property must be owned for more than one year
  2. Property must be used in their business as an income-producing activity, or held as investment property
  3. Property must have a measurable useful life – it has to be something that will eventually deteriorate or become obsolete

How Does Depreciation Work?

If it meets all requirements, the property may begin reflecting depreciation immediately after the property was placed in service, or when it becomes available for rental or other use.

Today, most real estate is depreciated using the straight-line method. It allocates the asset’s cost evenly over its useful life.

As for a real estate property’s useful lifespan, the IRS decided that:

  • The useful life of residential rental property is 27.5 years
  • The useful life of commercial property is 39 years

Using this information, here’s an example:

Let’s say we purchased a rental property for $100,000.

First, we have to determine how much of that cost represents the land and how much covers the structure.

Let's say we determined that the cost of the land was $30,000. That would leave $70,000 as the cost of the building.

Because this is rental real estate, we take the building value and divide it by 27.5 years:

$70,000 ÷ 27.5 years = $2,545.45

That would give us an annual deduction of $2,545.

That’s a pretty good break on your tax return, every year, for 27.5 years.

Other Depreciable Assets

Another type of depreciable asset is capital improvement, which is something that improves the property’s overall value and/or extends its useful life.

Adding a deck on the second floor of the property is an example of a capital improvement. Fixing a leak, on the other hand, is considered a repair, not a capital improvement.

Repairs are not depreciable; you must deduct the entire cost in the year they were done.

Personal property items like appliances and other equipment are depreciable, but they fall under a much shorter depreciation schedule (five to seven years) because they deteriorate that much faster.

Unique Benefits of Depreciation for Real Estate

On top of an annual, decades-long tax break, there are additional ways in which real estate investors, in particular, benefit from depreciation.

1. Real estate doesn’t often lose market value

Unlike other depreciable assets, property value can appreciate over time.

Even if the value of the property increases over time, because the value of the building depreciates, it reduces its tax liability, which in turn reduces the amount of tax that needs to be paid.

2. Depreciation can change a cash-positive rental to a negative-cash-flow property eligible for tax deductions.

It’s common for a cash-positive real estate investment to turn into a loss because of depreciation expenses.

But it doesn’t actually affect the cash flow. It’s called a “paper loss” because it only makes the taxable income lower than the cash flow on paper, which is a good thing for property owners.

The larger the depreciation expense, the lower the property owner’s reported net income. And that means paying lower taxes while still making a profit.

3. Depreciation isn’t the only tax credit available

Tax deductions for depreciation are only part of the picture – investors also get tax breaks on things like property maintenance and other expenses, which can decrease the net rental income.

With less net income, more tax cuts are allowed, resulting in a lower tax liability.

And paying less tax means more money to invest in other properties, improve current properties, or pay off a loan.

Depreciation Recapture

What happens when an investor depreciates a property and then sells it?

If the property is sold for more than its depreciated value, which is the basis in the property, the property owner must pay a Depreciation Recapture Tax, which is 25% to the IRS on the profit gained.

But the amount of profit that gets taxed is limited to the total sum of depreciation deductions taken. Anything above that sum gets taxed at the capital gains rate of 15%.

There are ways to avoid paying Depreciation Recapture Tax, such as:

  • Never selling the property and passing it down to an heir
  • Using the 1031 Exchange to defer the tax
  • Selling the property at a loss

Catch-Up Depreciation

The government actually requires that real estate property be depreciated.

Regardless of whether or not depreciation deductions were claimed by the property owner, upon the sale of the property, the 25% Depreciation Recapture Tax payment is required.

So, it’s in the best interest of investors to take advantage of depreciation deductions while they own the property.

But because of the complexities of depreciation and tax laws, it’s easy to make mistakes and not claim the deductions at all, or to claim them improperly.

To make life easier for property owners, the IRS created a procedure that basically allows people to play catch-up on the depreciation deductions that they’ve missed. A recent change in laws allows taxpayers to amend, and even consolidate, past deductions in one tax year - even on properties they’ve already sold.

That said, it’s always easier to avoid amendments from the outset.

Best to Leave It to the CPA

Property tax laws are complicated, and they change regularly.

It’s recommended for investors to consult with a Certified Public Accountant who can assess each individual situation. A CPA can help you make smart choices that will lower your tax burden.

As an investor, it’s important to know the basics: what depreciation is, how it works, why it’s beneficial, and other main ideas behind the concept.

But as far as technical information goes, it’s best to work with your CPA to come up with the best solutions.

Cardone Capital works with the industry’s best tax professionals to ensure that the maximum tax benefits are realized on all of their investments.

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