Tax Strategies - depreciation

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What is Real Estate Depreciation?

Real estate depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property placed into service by the investor.  Depreciation is essentially a non-cash deduction that reduces the investor’s taxable income.  Many investors refer to it as a “phantom” expense because they are not actually writing a check. It is merely the IRS allowing them to take a tax deduction based on the perceived decrease in the value of the real estate.  Real estate depreciation assumes that the rental property is actually declining over time as a result of wear and tear.  But we know this is not typically the case.  Not many other forms of investment offer comparable depreciation deductions.  As a result of real estate depreciation, the investor may actually have cash flow from the property but may show a tax loss.

What is the Benefit of Showing an Investment Property Tax Depreciation?

The benefit of course is to lower the overall tax liability (subject to certain limitations).  This can help real estate investors save hundreds to thousands per year or more  on their taxes.

Definition of Depreciable Property

To take a deduction for depreciation on a rental property, the property must meet specific criteria. According to the IRS:

• You must own the property, not be renting or borrowing it from someone else
• You must use the property to produce income—in this case, by renting it
• You must be able to determine a "useful life" for the property.  This means that the property must be one that would eventually wear out or get "used up." A house has a definable useful life; a piece of land does not.
• The property's useful life is longer than one year.  If the property would get used up or worn out in a year, you would typically deduct the entire cost as a regular rental expense.

A Closer Look

First of all, land is not depreciable.  But assuming you have rental real estate, you can depreciate the building, significant improvements, and any equipment that is used in the operation of the property.  Depreciation commences when a taxpayer places property in service and ends when the property is disposed of or otherwise retired from service.  Any depreciation that was taken will reduce the investor’s basis in the property.  Upon disposition of the property, this depreciation is essentially recaptured.

How to Calculate Real Estate Depreciation in 3 Simple Steps

The actual real estate depreciation calculation is not too difficult. Here’s how you would calculate it in 3 simple steps:

1. Real estate value is made of land and building values, but depreciation only applies to the building . First step is to allocate the property’s purchase price should be allocated between land and building value.
2. Since land is not subject to depreciation, the building  would be depreciated over the IRS prescribed useful life.  This life is  designated as 27.5 years for residential rental property and 39 years for  commercial property.  Divide your building value by 27.5 to get your depreciation expense.
3. Multiply the depreciation expense by your marginal tax rate to get your property tax savings from real estate depreciation.

Calculating Real Estate Depreciation Using an Example

We’ll apply the calculation using a $300,000 single-family home purchase.

1. Separate your land and building values, which you can also get from a tax assessment. Here, land value is $100,000 and building value is $200,000.
2. Divide your building value by 27.5, which is the number of years IRS has prescribed as the useful life of a residential property.  This is your annual depreciation of your residential investment property.
3. Multiply this annual depreciation by your marginal tax rate.  If you need more information on the marginal tax rate check with the IRS.

Real estate depreciation is a critical tax deduction for real estate investors and should not be overlooked . It is important for the real estate investor to understand the basics of depreciation.  This will assist the investor with tax planning and help them understand after-tax investment returns.

Depreciating Improvements

You don't just depreciate the cost of buying rental property.  Money spent to improve the property is depreciated as well.  An improvement is anything that enhances the value or usefulness of a property, restores it to new or like-new condition, or adapts it to a new use.  The list of potential improvements is endless, but common improvements include:

• Building new additions or garages
• Installing new systems, such as heating or air  conditioning
• Replacing the roof
• Adding wall-to-wall carpeting
• Installing accessibility upgrades, such as a wheelchair ramp

Routine repairs and maintenance are not considered improvements.  Maintenance costs are deducted as expenses in the year you spend the money.  For example, replacement of an entire roof would be depreciated. Additionally, the IRS allows a principle called “Cost Segregation” to be used on multifamily properties in which various components contained within the real estate can be depreciated on different, and faster, time steps enabling additional deductions.

How Long It Lasts

You start taking depreciation deductions not when you buy it but when you begin using the property to generate rental income.  The IRS refers to this as putting the property "in service. " Depreciation continues until one of two things happens:

• You have deducted your entire "cost basis" in the property . In most cases, your cost basis is what it cost you to acquire the property, including certain taxes and fees paid at settlement, plus any improvements to the property.
• You remove the property from service—meaning, you stop using it to generate income.  This may be because you sold the property or just decided to stop renting it.