SS165: What is Depreciation in Real Estate

SS165: What is Depreciation in Real Estate

Real estate depreciation is one of the most powerful tax benefits associated with real estate investing. In this episode, Charles discusses real estate depreciation and how it works.

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Talking Points:

  • Real estate depreciation is an essential tax-saving instrument for real estate investors. I am not an accountant or CPA, so speak to one for specific tax advice. However, my goal with this episode is to broadly outline real estate depreciation and how real estate investors of all sizes can utilize this powerful tax-saving tool.
  • Real estate depreciation allows investors to depreciate the value of buildings and property improvements at your rental property. Important to note that you cannot depreciate the land on which buildings are built.
  • Real estate depreciation begins when a rental property is available for tenant use.
  • The IRS allows real estate investors to deduct a specific amount yearly, typically 3.636% each year for 27.5 years for residential rental properties. Commercial properties have a 39-year recovery period, meaning that commercial real estate investors deduct their property’s improvements over 39 years, not 27.5. Which translates to a depreciation deduction of approximately 2.56% per year.
  • Cost segregation and bonus depreciation can increase the amount of depreciation, greatly reducing an investor’s tax bill, and this is usually done right after a property is purchased, but this is for another episode since these are more advanced real estate deprecation strategies.
  • Real estate depreciation is a phantom expense since investors do not actually have to pay a depreciation expense. It shows the present value of the rental property, allowing investors to deduct a percentage of their property’s improvements to account for wear and tear during its useful life.
  • Real estate depreciation helps to offset an investor’s tax liability since depreciation can be deducted from earnings.
  • According to the IRS, you can depreciate a rental property if it meets all of these requirements:
    • You own the property (you are considered the owner even if the property is subject to a debt).
    • You use the property in your business or as an income-producing activity.
    • The property has a determinable useful life, meaning it wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
    • The property is expected to last for more than one year
  • How does an investor calculate real estate depreciation? This is a very simple example: you should speak to your CPA to accurately determine your property’s real estate depreciation.
    • 1st, you determine the cost basis. You are determining the value of the actual rental house. If you purchased a property for $120,000, and you determine the cost of the house itself is $90,000, and you then add the improvements you made to the property, say you installed a new roof for $10,000. Now, the adjusted basis is about $100,000 – $120,000, the value of the property minus $30,000, the value of the land plus $10,000 = the value of the capital improvements.
    • 2nd, choose the depreciation method. We will use the straight-line 27.5-year recovery period I discussed previously.
    • 3rd, determine the depreciation amount of approximately 3.6% of the adjusted basis each year or about $3,600.
    • To see how powerful this is, if you owned this rental property and it generated, say, $5,000 a year in taxable income, you can now deduct over $3,600 from the $5,000, leaving you with a taxable income of only $1,400. A very powerful tax planning tool, especially for high-income investors.
  • One more important aspect of real estate depreciation is that if you sell a property for more than your purchase price, you might be subject to depreciation recapture, which is income tax on the gain at your normal income tax rate. That is why you must consult your accountant before purchasing or selling any property.
  • But recapture is not the end of the world; it rewards property owners who hold their property for many years and pass it to their heirs. However, even if you can depreciate the majority of your taxable income from a rental property that you have owned for, say, 10 years, you are not planning on buying another property, and the depreciation is recaptured, you are paying income taxes from many years prior at a much later date, with cheaper dollars. Allowing you to invest your tax savings over those years while inflation erodes the value of those dollars.
  • The exact reason why many wealthy real estate investors hold their properties for many years.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo, and today we’re going to be discussing what is depreciation in real estate.

Charles:
Have you always wanted to invest in real estate, but didn’t have the time, didn’t know where to find the deals, couldn’t get the funding and didn’t want tenants calling you. Since 2006, I’ve been buying income producing properties and great locations that provide us with consistent passive income. While we wait for appreciation in the future and take advantage of tax laws while we’re waiting and unlike your financial advisor, we invest alongside our investors in every property we purchase. Check out to investwithharborside.com. If you like the idea of investing real estate, if you like the idea of passive income partner with us at investwithharborside.com, that’s investwithharborside.com.

Charles:
Real estate depreciation is an essential tax saving instrument for real estate investors. I’m not an ACCOUNTER or CPA, so speak to one for specific tax advice.

Charles:
You should already have one if you own a rental property. However, my goal with this episode is broadly outlined real estate depreciation and how real estate investors of all sizes can utilize this powerful tax saving tool. So real estate depreciation allows investors to depreciate the value of buildings and property improvements at your rental property. Important to note that you cannot depreciate the land on which buildings are built. Real estate depreciation begins when a rental property is available for tenant use. The IRS allows real estate investors to deduct a specific amount yearly, typically 3.636% a year for 27 and a half years for residential rental properties. Commercial properties have a 39 year recovery period, meaning that commercial real estate investors deduct their properties improvements over 39 years, not 27 and a half years, which translate to its depreciation deduction of approximately 2.56 per year. So residential property owners are able to deduct more per year than commercial owners.

Charles:
Now, some other tactics you’ve probably heard, like call segregation bonus depreciation can increase the amount of depreciation greatly reducing an investor’s tax bill. And this is usually done right after a property is purchased, but this is for another episode. Since these are more advanced real estate depreciation strategies, real estate depreciation is a phantom expense since investors do not actually have to pay a depreciation expense or write a check to pay depreciation expense. And it shows the present value of the rental property, allowing investors to deduct a percentage of the property’s improvements to account for wear and tear during its useful life. Real estate depreciation helps to offset an investor’s tax liability since depreciation can be deducted from earnings. Now, according to the IRS, you can depreciate a rental property if it meets the following requirements. You own the property, you use the property in your business, or as an income producing activity, the property has a determinable useful life, meaning it wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.

Charles:
And the property is expected to last for more than one year. So you’re planning on owning this property for more than one year. So how does an investor calculate real estate depreciation? And this is a very simple example, we’re on a podcast. You should speak to your CPA to accurately determine your property’s real estate depreciation. But first you determine the cost basis. Now you’re determining the value of the actual rental house on the property. If you purchase a property for say, $120,000, you determine the cost of the house itself is $90,000. You then add the improvements you made to the property. Say you installed a new roof for $10,000. Now the adjusted basis is about a hundred thousand dollars, $120,000, which was the value of the property minus $30,000. The value you determined was the value of the land plus $10,000. The value of the capital improvements, the new roof leaves you with a hundred thousand dollars adjusted basis.

Charles:
Second, you choose the depreciation method and we are gonna use the straight line 27 and a half year recovery period and 30 determine the depreciation amount, which is approximately 3.6%. So it’s gonna be about $3,600 per year in this example. Now to see how powerful this is, if you own this rental property and it generate, say, $5,000 a year in taxable income. So after all your expenses, you made $5,000 a year, you can now deduct over $3,600 from the $5,000 leaving you with a taxable income of only about $1,400. A very powerful tax planning tool, especially for high income investors. Now, one more important aspect of real estate depreciation is that if you sell a property for more than your purchase price, you might be subject to depreciation recapture, which is income tax on the gain at your normal income tax rate. This is why you must consult your accountant before purchasing or before planning to sell any property.

Charles:
But the cap recapture is not the end of the world. It rewards property owners who hold their property for many years and pass it to their heirs. However, even if you can depreciate the, the majority of your taxable income from a rental property that you’ve owned for say, 10 years, and you’re not planning on buying another property, the depreciation is recaptured in your paying income taxes many years after they were due. So it’s with much cheaper dollars allowing you to invest your tax savings over those years while inflation inflation erodes the value of those dollars. For example, in our example above a hundred thousand dollars, say we own that for 10 years, we depreciate $36,000. So we’re able to offset $36,000 income and kind of push that, push that kick that can down the road. Even if you didn’t buy another property when you sold that property and that $36,000 for recaptured, you’re paying that many years down the road.

Charles:
It could be worth, depending on how inflation is at the time it could be worth a fraction of what it would’ve been 10 years earlier. If you buy another property during the same year, this is where even more savings can happen. Speak to your accountant ’cause you’re gonna let them know what you’re planning on buying. Or the first question they’re gonna have when you tell ’em you wanna buy, sell a rental property is what are you planning to do with the money? And that’s where it gets interesting and that’s where you can talk to ’em. Now, the depreciation is the exact reason why many real wealthy real estate investors hold their properties for many years and why many high income earners invest in real estate. So I hope you enjoyed, please remember to rate, review, subscribe, some, make comments and potential show topics@globalinvestorspodcast.com. If you’re interested in actively investing in real estate, please check out our courses and mentoring programs@syndicationsuperstars.com. That is syndication superstars.com. Look forward to two more episodes next week. See you then.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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