If you take a loss in real estate, it isn’t a good thing. Or is it?
Real estate depreciation is an example of a “loss” that actually benefits the investor. Real estate depreciation is a benefit that attracts many investors to real estate, allowing owners of the property to save money on taxes.
But this real estate benefit is often misunderstood, especially when it comes to commercial real estate. So we’re giving you the rundown on the ins and outs of depreciation when it comes to multifamily investing.
What is Real Estate Depreciation?
Depreciation refers to the idea that all real estate, besides the land itself, has a finite useful life. Think of a bed, or a kitchen table. These items will decline in quality and usefulness overtime from wear and tear. The same applies to apartment complexes. The buildings, appliances, pavement, and stairs will all decline in condition as time passes. Many building features and fixtures will break or need repair or replacement, especially as they become outdated or newer trends and models come out.
Owners of cash-flowing real estate can benefit from the IRS allowing the subtraction of the property's purchase price and renovation costs from taxable income during its useful life. This practice assigns value to the property's natural wear and tear and enables owners to write off the expense as a loss, reducing their taxable income and maximizing their profits.
Owners of income-generating real estate can receive a tax deduction over an extended period, usually 27.5 years, by distributing the write-off of the purchase price and renovations.
Determining Real Estate Depreciation
Publication 527 by the IRS serves as a comprehensive guide to determine the appropriate way of claiming depreciation. It is crucial to familiarize yourself with the publication and seek advice from a tax expert prior to writing off depreciation as a business expense. The calculation of the final depreciation value involves several factors, making it essential to have a clear understanding of the process.
Once a property is available for rent, it is considered to be in service. During this period, the depreciation amount can be deducted from the taxable income until the property is retired from service. If the owners decide to take the property offline temporarily for maintenance or renovations, it is still eligible for depreciation purposes. Therefore, property owners can take advantage of this tax benefit even when making improvements to their property.
What Is the Property’s Cost Basis?
The initial step in determining the property's depreciable value over time is to establish the cost basis. This is computed by subtracting the land value from the property's purchase price and then factoring in any repair or renovation expenses that the current owner has covered.
Next Up - The “Over X Number of Years” Part
Depreciation is a tax benefit that occurs over the course of several years. The duration of time for which real property is deducted is either 27.5 years or 30 years, contingent on which depreciation strategy is being used. Most property owners opt for the 27.5-year span, which is part of the General Depreciation System (GDS). However, the 30-year duration is reserved for properties that qualify for the Alternative Depreciation System (ADS). These include properties that are not used for business purposes for over 50% of the time, tax-exempt properties, farms, and those using tax-exempt bond financing.
The IRS mandates that property owners use the GDS unless ADS is required or the owner is eligible for ADS and decides to use it. Using the right depreciation method can significantly reduce taxable income, as the property owner can deduct the asset's purchase price and the value of renovations over its useful life. This means that property owners can write off the natural wear and tear of the property as a business expense, resulting in decreased taxable income.
Breaking it Down
In multifamily properties, there are various items that have unique depreciation timelines, distinct from the typical 27.5 to 30 years. For instance, shrubbery and fencing can be depreciated over 15 years, while appliances, carpet, and furniture have shorter recovery periods of 5 years. Keeping track of these timelines can help property owners maximize their tax deductions.
Taking depreciation on a property is a complex process, especially if bonus depreciation is involved. This is why owners often involve a tax professional to conduct a cost segregation study, which helps the owner maximize their depreciation deduction.
Is Bonus Depreciation Extra Depreciation?
The answer is no, not really. Bonus depreciation is an alternative to the multi-year depreciation scheduled outlined by the IRS (which we just discussed). Multifamily property owners can decide to deduct expense items with bonus depreciation.
One way to potentially reduce taxable income in the multifamily real estate industry is through bonus depreciation, which offers a significant one-time deduction of depreciation expenses for various essential assets that help properties function properly. These assets include not only physical property but also software with a useful life of 20 years or less. By taking advantage of this opportunity, owners can potentially save a considerable amount of money on taxes.
Furthermore, owners can also use bonus depreciation to deduct costs associated with appliances, fixtures, furniture, software, and even landscaping. This approach offers a practical way to recoup costs for various items used in the multifamily industry, potentially resulting in significant savings in taxable income.
What About The Tax Cuts and Jobs Act?
The year 2017 marked the passing of the Tax Cuts and Jobs Act which brought about a significant change in the bonus depreciation amount. This change allowed property owners to expense the entire cost of depreciable purchases in the same year they were acquired. However, the bonus depreciation rate is set to gradually decrease from its 100% rate starting in January 2023 and will eventually be phased out entirely by January 2027.
So Does That Mean I Won’t Pay Any Taxes?
Unfortunately, real estate owners shouldn't expect depreciation benefits to completely eliminate their tax liability since it's a deduction and not a credit. Moreover, the annual percentage deducted isn't significant. Take for instance, in a 27.5 year recovery period, only 3.636% of the property's cost basis is allocated to depreciation expenses.
Real estate investment offers numerous advantages, including the ability to decrease taxable income through writing off depreciation expenses. Investors in multifamily syndications, including passive investors, can optimize these benefits by seeking the guidance of a tax professional. With their expertise, investors can develop a strategic plan to retain more of their hard-earned income and minimize their tax liability. By taking advantage of these opportunities, investors can boost their returns and achieve their financial goals.
Oh yeah, and P.S.: Donis Investment Group and its representatives do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.