Suppose you own an investment property for 30 years. Over the course of ownership, the property will depreciate. Depreciation is a tax method used by businesses to deduct a portion of an asset’s value uniformly each year as the asset’s value declines. This deduction helps offset income earned by the asset or business.
If you have invested in real property, I am sure you have felt somewhat unsure how depreciation will affect your tax returns. Because while the structure itself should last (at least) 30 years, what about the roof, windows, or plumbing? Will everything in the building be in the same condition after three decades of use? Absolutely not.
That is why it is important to understand the concept of accelerated depreciation, which is kind of the greatest thing since sliced bread—at least for real estate investors.
Maximize Your Deductions
Savvy investors try to frontload their depreciation as much and as soon as possible. This is accelerated depreciation in a nutshell.
There are different rules and nuances, but the goal is to write individual portions of your asset off (carpets, HVAC systems, electrical systems) in the early years of owning an asset, dramatically reducing reported earnings and, ultimately, any taxes owed.
Let’s look at an example of depreciation:
A business pays $100,000 for equipment that is expected to last for 10 years. The business can deduct $10,000 per year against any income to account for wear and tear. After 10 years, the asset will have no value left on the books. If you are a real estate investor who purchases a residential property for $1,000,000, you can deduct depreciation over 27.5 years—or about $36,360 per year. But wait, it gets better.
Accelerated Depreciation in Real Estate
What makes a real estate investment such a standout investment, among other reasons, is the ability to depreciate the individual elements of the property.
Typically, real estate is depreciated over 27.5 (residential) or 39 years (commercial). But with a cost segregation study, you can properly identify all the parts of the property—from non-structural to structural—and use an accelerated depreciation schedule for some of those components (equipment, flooring, roof, etc). Note that land does not depreciate.
When you own investment property, those early years can be crucial to scaling your business. The ability to generate more cash through these tax benefits are designed to help you achieve your goals.
Theoretically, you could owe ZERO taxes in the first few years of ownership by leveraging accelerated depreciation. Imagine the potential savings of that tax deferral and all the ways you could grow your portfolio of assets instead.
Beware of Depreciation Recapture
What happens when you sell the property? Whether or not you claim depreciation on your taxes, you will be liable for it when you sell, so be sure to work with a qualified tax professional to claim any allowable depreciation.
Let’s say over a five-year investment, the annual depreciation deduction has allowed you to defer those taxes. Now that your property is sold at a gain, the depreciation deducted is recaptured at a 25% tax rate (with any remaining gains taxed as capital gains). That’s often lower than an investor’s ordinary tax rate.
But, wait! There is still more. If you are an active real estate professional, any depreciation deductions from your passive investments can offset your active income. This is a great strategy for real estate brokers, property managers, contractors, and other real estate–related professions.
From my own experience, every passive investment I’ve made has produced more reported losses in the first five years than income, and brought in regular cash flow. Accelerated depreciation allowed me to dramatically reduce initial costs and use the first several years of owning the asset to reinvest for future growth.
Before You Go…
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