One reason why real estate makes a great investment vehicle is that it can offer significant tax benefits. One of the biggest of those benefits comes from depreciation. In this article, we’ll see what this means and how real estate depreciation can benefit you as a passive investor.
Before we go on, remember that everyone’s tax situation is different, and you should consult a tax professional before making any significant investments. I’m not a tax advisor, and everything I share here is based only on my own experience in real estate investing.
The good news for passive investors, such as those in the Picheny Investors Club, is that you don’t need to worry about all the intricacies of depreciation and can still enjoy the benefits.
I’m sharing the following with you to better educate you about the field, but these won’t be day-to-day concerns for you when you become a passive investor in real estate syndications.
What Is Depreciation?
The IRS deems that assets depreciate — or lose value — over time, because of wear and tear.
Although our interest here is in real estate investments, depreciation is relevant in lots of businesses. If you’ve ever seen businesses referring to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), you’ll know that depreciation can be a major factor in its finances.
Three important facts about depreciation in real estate:
- Land does not depreciate.
- The building does depreciate, and the magic number for residential properties is 27.5 years. This is the time over which a property depreciates to a value of zero.
- Contents & land improvements also depreciate, but on different schedules defined by the IRS.
Why 27.5 years? That’s what the IRS has deemed to be the useful life of residential property since implementing the Modified Accelerated Cost Recovery System (MACRS) in 1986.
I should reiterate here that we’re talking about residential properties. And without going into all the details, these tax advantages only apply if the residential property is available for rental all year long.
If you want to personally occupy the property, it must be for less than 14 nights per year. This is important when it comes to real estate investing — we don’t buy properties to live in them but rather to rent them, it’s a business.
Why Does Depreciation Matter?
You might wonder why all of this matters. If you own an asset and the IRS believes it will naturally depreciate over time, that means you should end up with less than you started with, right?
Well, no. The news is much better than that. As your property depreciates, this is recorded on your financial records as a loss. You get to count that loss against your income, which offsets the taxes due.
If the depreciation is equal to, or more than, the income generated from renting the property, you will not owe taxes on the income the property generates.
That’s correct: your property could generate you an annual income with no taxes due. Now you can see why depreciation is more exciting than it sounds!
When used right (and that’s where checking with your CPA is essential), depreciation can save you a lot of money, making it one of the most powerful benefits of being a real estate investor.
Let’s look at this with a simple example.
Depreciation Example
Because residential property depreciates over 27.5 years, I’ll use an example that makes the math work nicely.
Let’s say you purchase a property for $375,000.
Let’s say the land is worth $100,000. (Remember, the land doesn’t depreciate.)
That leaves $275,000.
If this depreciates to zero over 27.5 years, the depreciation rate is $10,000 each year.
Now, let’s say you have five units on the property that rents for $500 per month. That generates $2,500 per month or $30,000 per year.
If your expenses were $20,000 for the year, that leaves a $10,000 profit from a cash perspective.
And here’s the great news: because the $10,000 depreciation offsets the $10,000 profit, you would not owe a dime in taxes on the income from the property that year.
Partnerships and K1s
All of the deals I have invested in are taxed as a partnership.
This means the company files a tax return at the end of the year and provides me with a K1 that shows my portion of the company’s profits or losses.
The company does not pay corporate tax. Instead, I pay taxes equal to my ownership in the company, based on my particular tax situation. My CPA uses the K1 document when determining my overall taxes for the year.
Because of depreciation, such as in the above example, these K1s usually provide me with significant tax savings during the time that we own the property.
Cost Segregation
While a residential property depreciates over 27.5 years, there are different schedules for the depreciation of personal property inside the building, as well as for land improvements (landscaping, parking lots, etc).
Figuring out what is depreciable and how each item depreciates is the job of a qualified engineer. You can hire this professional to conduct an audit and the result is called a cost segregation study. A tax preparer uses this when preparing the tax return for the owner(s) of the property.
The benefit of a cost segregation study is that it allows the property owners to depreciate the different portions of the property according to the IRS rules. This is often much quicker than 27.5 years — some items depreciate as quickly as 5 years. This results in more substantial tax savings in the earlier years of ownership.
What Is Bonus Depreciation?
Depreciation is undoubtedly a good thing for real estate investors. Bonus depreciation takes it up a level, giving real estate deals an even greater tax advantage.
Bonus depreciation applies to any property placed in service after September 27, 2017, thanks to the 2017 Tax Cut and Jobs Act (TCJA).
So, what is it? Bonus depreciation allows you to depreciate the property at an even faster pace. Specifically, everything that depreciates in 20 years or less can be fully depreciated in the first year of property ownership.
“Bonus” is putting it mildly here: this type of depreciation typically represents between 70% and 100% of the initial down payment on a property. In some cases, it can be over 100%! Imagine receiving a K1 that shows a loss that is greater than your investment in the deal.
As you might expect, there’s more to this than just checking a box and grabbing a load of cash. The property, the segregation study, and your tax situation will all have a bearing on the extent to which you can take advantage of bonus depreciation.
There’s also depreciation recapture to keep in mind.
How Will Depreciation Change In The Future?
Jeff Bezos of Amazon once said that he wasn’t interested in what was going to change but rather in what wouldn’t because he could build a business around things that stay the same.
And that’s the way it is with depreciation. The 27.5-year rule around asset depreciation for residential properties has been around since 1986, and there’s no sign of this changing. Nor is there any sign of cost segregation changing. As long as Congress doesn’t make any changes — and there’s no reason to think they will — depreciation will continue to be one of the key benefits available to real estate investors.
In short, the tax benefits you can get from depreciation on your real estate investments are highly likely to be available for many years to come. But you should know that the Bonus Deprecation from the TCJA mentioned above is temporary — it will sunset from 2023 through to 2027.