Real Estate Depreciation 101: What You Need to Know
Real estate depreciation… no, not the kind you feel after your neighbor bought a house next to yours at half the price, but the kind that can put more money in your pocket. To stimulate investments in real estate, and thus the economy, the congress enacted tax benefits towards real estate investments in 1971. There are typically two methods for deducting depreciation, either the declining balance switching to straight line, or just straight line. Most people take a straight line approach towards depreciation.
In a straight line model for depreciation, a tax payer must calculate tax deductions using specific lives and methods. Assets are typically divided into classes by the type of asset, or by the business in which the asset is used. Based upon this, they then can then decide how to depreciate their asset. Unless required to use the alternative depreciation system, a taxpayer decides which of the two lives to choose (for real estate). Land improvements must be depreciated over 15 or 20 years, while other real property must be depreciated over 27.5 years for residential property, or 39 years for business property.
What must be remembered is that only the real property, not the land can be depreciated. So upon acquisition an owner and their accountant must determine what the value of the land vs. the total value of the property is, and subtract the land value to determine their basis for depreciation. As each year passes, the basis declines by the amount of depreciation (approximately 3.63% for a residential property (1/27.5) and 2.56% for a commercial property (1/39)) until there is no longer any basis. During this time, the investor receives the benefit of depreciation by offsetting their income by the depreciated amount. Say for example an investor purchases a multi-family residential building for a million dollars; the investor and his accountant allocate $700,000 to the building and $300,000 to the land. This investor would be entitled to depreciate $25,455 a year under a straight line depreciation method, assuming this investor is in the 40% tax bracket, this would equate to additional cash flow of $10,182 a year. Assuming that the investor purchased the property at a 6.0% capitalization rate, this would actually increase the cash flow by as much as 17%.
An additional benefit, not as commonly used, utilizes depreciation strategies. One such strategy is to use accelerated depreciation. There are many methods to accelerate the depreciation of an asset, including the sum of the years and double declining balance methods. An additional alternative is to hire a third party to create a depreciation schedule of all of the fixtures of the assets.
Of course, depreciation is not free money. Upon the sale of an asset, the depreciation is recaptured, and taxed at either normal income, or at 25%. To offset this many investors utilize the 1031 tax deferred exchange process. In this process, the asset that has been sold (the downleg, which is typically one that the investor has already received substantial depreciation benefits, or one that has realized substantial appreciation) is placed with an accommodator, the investor typically then has up to 45 days to identify an exchange property (the upleg) and a total of 180 days to close escrow on the upleg. By finding an upleg that is higher in price, and utilizing leverage, an investor can increase their basis and thus receive additional depreciation benefits. I have seen investors successfully increase cash flow by as much as 35% by utilizing the above strategies.
Although depreciation is not as sexy sounding as the asset, it is an integral and important aspect towards real estate investing, and every investor should take this into consideration, and consult with their advisors, including their C.P.A., financial advisor, and of course their real estate broker so that they find the right property to fit their tax strategies.