Depreciation is one of the biggest and most important deductions for rental real estate investors because it reduces taxable income but not cash flow. It’s also a big topic in our comprehensive Rental Property Tax Guide developed with the Real Estate CPA. For many landlords, the most important part here will be determining a property’s depreciable basis.
Simply put, depreciation allows real estate investors to depreciate a property over a period of time—27.5 years—in order to benefit from the yearly tax loss. For instance, if you own a property and allocate $200,000 of the acquisition cost to the improvements, you would be allowed to depreciate $7,272 a year ($200,000/27.5) as a tax loss. That’s a huge benefit that can offset the income generated by the rental property—ultimately lowering your year-end tax burden.
Why Depreciate a Rental Property?
The goal is to allocate as much of the property’s purchase price to the building value as possible to maximize your depreciation expense since land is never depreciated. The portion allocated to the building will be depreciated over 27.5 years, per the IRS guidelines for residential income property.
While allocating 20% to land and 80% to the building is a common practice, under an audit you may have to substantiate why you chose these numbers. This is commonly done by finding the land versus building value on an appraisal or property tax card filed with the county.
You can also use comparable land sales to make this determination or commission a cost segregation study or appraisal by a third-party professional. Should you decide to deviate from the county tax assessor’s land versus building value ratio, you’ll need to be prepared to support your determination in an audit with independent documentation prepared by a third-party professional.
Cost Segregation Studies and 100% Bonus Depreciation
In a cost segregation study, certain costs previously classified as 27.5 year property, are instead classified as personal property or land improvements, with a shorter 5, 7, or 15-year rate of depreciation. These use accelerated methods to increase your near-term deductions. It sounds complicated, but most tax accountants and some software will do the math for you.
Generally between 20-30% of the property’s purchase price can be reclassified under these shorter class lives which can significantly increase a property’s depreciation expense. Thanks to The Tax Cuts and Jobs Act, 5, 7, and 15-year property is now eligible for 100% bonus depreciation, which means its entire cost can be written off in the first year of ownership.
Let’s Take an Example…
A building with an improvements value of $100,000 will typically have $3,636 in annual depreciation ($100,000/27.5). However, if you were to commission a cost segregation study and find that 20% of the building’s value can be reclassified as personal property or land improvements, you could then deduct $20,000 in 100% bonus depreciation, and enjoy another $2,909 in regular annual depreciation for a total depreciation deduction of $22,909 in the first year.
It’s important to note that cost segregation studies make the most sense for landlords who are considered real estate professionals for tax purposes or expect to come in under the passive loss limits discussed below. Otherwise, you may not be able to put the dramatically higher first year depreciation expense to use unless you consistently have other net income from passive activities or a capital gain from the sale of a rental. Keep in mind that losses generated by rental properties can generally offset other passive income or gain from the sale of rental property.
Don’t Forget About Depreciation Recapture
The downside of depreciation is depreciation recapture, which rears its claws upon sale of a depreciated asset. Depreciation recapture is the portion of your gain attributable to the depreciation you took on your property during prior years of ownership, also known as accumulated depreciation. Depreciation recapture is taxed as ordinary income up to a maximum rate of 25%.
Depreciation Recapture Example…
Imagine you purchased a rental property in 2010 and allocated $275,000 to the improvements. You then sold it in 2018 for $450,000. Each year your depreciation expense was $10,000 ($275,000 / 27.5) for a total of $80,000 in depreciation over 8 years. This lowered your adjusted basis in the property to $195,000 making your total gain on sale $255,000 ($450,000 – $195,000).
The $80,000 of gain from depreciation is taxed at 25% for a total of $20,000. The remaining gain of $175,000 is taxed at the long-term capital gains rate of 15% for a total of $26,250. Also, because your total income was above $200,000, the entire gain of $255,000 is subject to the 3.8 NIIT for a total of $9,690. When you add this all up your total tax upon sale is $55,940 or nearly 22% of the total gain. You may also be liable for state taxes, depending on your geography.
Dive Deeper on Depreciation
Depreciation can be a powerful tax strategy when used effectively and under the right circumstances. You do not have to pay anything in order to claim a depreciation expense each year, as you already own the asset.
Although as real estate investors we know that—for the most part—our property assets do not depreciate over time, this tax strategy is regularly used to put more money in your pocket in order to redeploy elsewhere. As always, it’s important to discuss this strategy with your accounting professional, and if you want to learn more, check out our more comprehensive guide on tax strategies for real estate investors.