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Tax benefits of accelerated depreciation on rental property

wooden houses with downward graph
by Jeff Rohde, posted in Investment Strategy

The 3 main reasons for investing in rental property are recurring income, the potential for equity appreciation over the long term, and unique tax benefits

One of the most significant tax benefits of owning rental property is the use of depreciation expenses to reduce taxable income. An even bigger tax benefit is accelerated depreciation. In some cases, an investor may be able to accelerate depreciation to generate a paper loss, even when a rental property has positive net income.

Let’s look at residential real estate depreciation and explain how accelerated depreciation on rental property can significantly reduce a tax burden.

Key takeaways

  • Depreciation is a noncash expense real estate investors can claim to offset pretax net income.
  • The 3 rental property depreciation types are straight-line, accelerated, and bonus depreciation.
  • Accelerated depreciation on rental property is a strategy used to front-load depreciation expenses during the first few years of ownership.
  • An investor may free up more cash for other uses by claiming accelerated depreciation, such as making improvements to increase rental income.
  • Paper losses from accelerated depreciation may be used to offset other profits on an investor’s tax return or carried forward to future tax years.


What is accelerated depreciation on rental property?

Depreciation is an annual deduction from pretax net income that allows real estate investors to recover the cost basis of real property during the time an investor owns the property. A good way to think of depreciation is as compensation for property wear and tear, deterioration, or obsolescence.

For depreciation purposes, cost basis includes the purchase price of the property less the value of the land or lot, plus costs that must be capitalized, such as the capital expense of replacing a roof or closing costs added to the basis like title insurance and recording fees.

Residential rental property is normally depreciated over a period of 27.5 years, with the depreciation expense spread evenly over the holding period. However, some components of a rental property, such as appliances, flooring, landscaping, and fencing, may be completely depreciated during the first 5 to 7 years of ownership. With accelerated depreciation, an investor can reduce pretax income even more during the first few years.

Before continuing, it’s worth noting that depreciation does not mean a rental property becomes less valuable to an owner or buyer when the property is sold. In fact, when a rental property is sold, the depreciation clock gets reset, and depreciation begins all over again for the new owner.

A well-maintained rental property generates cash flow year after year, often with annual rent price increases, while the median sales price of houses sold historically increases over an extended period of time.


person filing tax forms

How accelerated depreciation on rental property works

Straight-line depreciation is used to depreciate rental property by the same amount each year. 

Residential investment property is normally depreciated over a period of 27.5 years. So, if the cost basis of a rental property is $110,000, an owner may deduct $4,000 per year from pretax income for the next 27.5 years.

By conducting a cost segregation study, an investor can break down the cost basis of a rental property into different components to generate more of a paper loss during the early years of ownership.

The following example illustrates how accelerated depreciation on rental property works and the impact accelerating the depreciation has on pretax income compared to straight-line depreciation:

  • Property purchase price: $120,000
  • Land value: $10,000
  • Closing costs added to cost basis: $2,000
  • Value of appliances and flooring: $7,000 (included in purchase price)
  • Value of fence: $5,000 (included in purchase price)

The cost basis of the property for depreciation purposes is $112,000 and is determined by subtracting the land value of $10,000 from the $120,000 purchase price, then adding $2,000 in closing costs that must be included in the cost basis. 

To identify items that can be depreciated more quickly and their values, the owner performs a cost segregation study. The value of the appliances and flooring can be depreciated over a 5-year period, and the value of the fence can be depreciated over a 15-year period.

Now let’s look at how accelerated depreciation increases the total depreciation expense the owner in this example could claim and the effect on taxable net income. 

Pretax income is determined by subtracting operating expenses and mortgage interest expense from the total amount of rental income collected. The property cost basis in the accelerated depreciation column is determined by subtracting the value of the appliances, flooring, and fence from the total cost basis of $112,000:

By using accelerated depreciation, the investor in this example can claim a loss for tax purposes of $369 per year, even though the rental property has thousands of dollars in pretax net income. The loss can be used to offset profits from other investments in the current tax year, or the loss can be carried forward and used as a deduction in future tax years until the deduction is used up.


Bonus depreciation

Currently, real estate investors can claim 100% bonus depreciation on some properties that would normally be depreciated over 5, 7, and 15 years. 

Bonus depreciation applies to property acquired and placed into service after September 27, 2017, and before January 1, 2023. In 2023, the percentage of bonus depreciation a real estate investor can claim decreases by 20% each year until 2027, at which time the benefit expires.

By claiming bonus depreciation instead of accelerated depreciation, an investor front-loads depreciation expense to reduce taxable net income even more. To illustrate, we’ll use the previous example with an additional column for bonus depreciation:

Note that bonus depreciation is a one-time benefit. After the first year, the annual depreciation expense is reduced to $3,636 because the appliances, flooring, and fence have been fully depreciated.


Pros and cons of rental property accelerated depreciation

The most significant advantage of accelerating depreciation is reducing an investor’s taxable net income. The paper loss created by depreciation can be used to offset other profits in the same tax year, such as dividend income from a private REIT like Roofstock One or net income from other rental property in an investor’s portfolio. Any remaining loss can be carried forward into future tax years and be used to offset future gains until the loss is exhausted. 

One drawback to accelerated depreciation is that an investor needs to spend money on a cost segregation study to identify items that can be depreciated faster. The other disadvantage to depreciation is that it is recaptured and taxed when a rental property is sold. The maximum tax on recaptured depreciation is 25%, and the maximum tax on capital gains is 20%, depending on an investor’s income tax bracket. 

The good news is that both capital gains tax and depreciation recapture tax can be deferred by conducting a 1031 exchange. 

There are several rules the Internal Revenue Service (IRS) has for 1031 tax-deferred exchanges, including strict time frames for identifying and purchasing a replacement property.  The price of the replacement property and any mortgage balance must also be equal to or greater than the relinquished property, to avoid incurring a capital gains tax liability. Investors considering a 1031 exchange may wish to consult their tax advisor.


How to automatically track rental property depreciation

Accurately keeping track of depreciation, accelerated depreciation, bonus depreciation, depreciation recapture, and capital gains can be incredibly complicated, even with just one rental property.

While you could create a spreadsheet to track depreciation, a much easier way to automatically track rental property depreciation is by signing up for a free account with Stessa, a Roofstock company. 

The real estate balance sheet feature on Stessa keeps track of depreciation expenses. It automatically updates property value and outstanding mortgage balance to give you a more accurate idea of the owner’s equity. 

After linking business banking accounts and the mortgage account, Stessa automatically tracks income and expenses in real time. Rental property owners can monitor all of their investments from a single, comprehensive online dashboard to make more informed decisions for optimizing returns.


Final thoughts

Taking accelerated depreciation on rental property can be a good strategy for investors who want to have more cash in the first few years of ownership for upgrades or purchasing additional rental property. 

Before deciding on accelerating depreciation, it’s a good idea to speak with your certified public accountant (CPA) or financial advisor and visit the Stessa Tax Center to access a suite of tax resources created in partnership with The Real Estate CPA, a firm that specializes in real estate investments.

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