When it comes to real estate investing, many terms and concepts can be confusing for a new real estate investor. One of those concepts is depreciation deduction. Most real estate investors know that it’s a vital tax concept but put off understanding what it means.
In reality, depreciation in real estate is a fairly simple concept, and understanding its definition can help you make the most out of your investments.
This post discusses the definition of depreciation in real estate, how it works and why real estate investors need to understand it. However, consulting with a local tax adviser is still advisable since local tax regulations affect your real estate investments.
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What is Depreciation, and How is it Related to Real Estate?
Depreciation is an accounting method used to allocate the cost of a long-term asset over its useful life.
It’s an expense reported on the income statement as a revenue reduction. In the United States, the federal government allows taxpayers to deduct a portion of the cost of their real estate investments through the depreciation tax deduction.
Depreciation tax deductions can be claimed on any commercial and residential rental property and can be used to offset other income taxes.
Depreciation allows investors to write off the wear and tear that their rental properties experience over time. For example, if you purchase a rental property for $100,000 and it depreciates by 10% over ten years, you can write off $10,000 of the purchase price in your taxes each year.
How Does Depreciation Affect Real Estate?
There are a few things to remember when depreciating real estate.
First, only the “depreciable value” of a property can be written off—this generally excludes the value of the land on which the property is built. Land is not depreciable because dirt and rocks don’t deteriorate. The capital improvements built on the land, though, are part of the depreciation expense. Your accountant can devise a way to maximize the property’s depreciation by segregating the cost of the land and the building value.
Second, different types of properties depreciate at different rates. Commercial real estate takes 39 years to decline, while residential properties take 27.5 years. Personal residences can’t be depreciated. Only properties bought as an investment or used as a business are subject to depreciation.
Lastly, you can accelerate depreciation by introducing leasehold improvements. If you offer the property to a tenant, you can make nonstructural improvements that can be depreciated within 15 years.
How is Depreciation Calculated?
Investors should also be aware that there are two depreciation methods: straight-line and accelerated. The straight-line depreciation method spreads the deduction evenly over the asset’s useful life. The accelerated method allows investors to deduct more in the early years and less in the later years.
To use the straight-line method, subtract the property’s salvage value from the asset purchase price and divide it by useful life. The result is the annual depreciation. To deduct more depreciation in the early years, your accountant can work on a cost segregation method that lets you depreciate several components of the property upfront. This results in more savings in the beginning but less depreciation to claim in the future.
If you decide to sell the real estate property for more than its cost, less the depreciation claimed, the IRS can see the excess value and charge a depreciation recapture tax. This is 25% of the depreciation value, which the IRS considers as ordinary income.
How is the Depreciation Rate for Real Estate Determined, and What Factors are Considered?
The Internal Revenue Service (IRS) establishes the amortization rate for real estate based on the nature of the asset and its anticipated usable life.
The age and condition of the asset, the expected usable life of its different parts, and any improvements or renovations done are all variables that the IRS takes into account when calculating the depreciation rate. For instance, the IRS may give a shorter depreciation term to represent the property’s increased worth if it has experienced major upgrades or restorations. Understanding the variables that affect a property’s depreciation rate is crucial for real estate owners because it can significantly affect their tax obligation.
What are the Tax Benefits of Real Estate Depreciation, and How Does It Impact Property Owners’ Tax Liability?
For property owners, real estate amortization comes with a number of financial advantages and can significantly reduce their tax obligations. Depreciation lessens the amount of taxable revenue that property owners are required to disclose on their tax returns, which is one of its main advantages. This is so that the proprietor has to submit less taxable income since the depreciation cost is deducted from the property’s revenue.
Depreciation can assist property owners in lowering their tax obligations by reducing the amount of taxes they due, in addition to lowering taxable revenue. This is so that the depreciation expenditure can be used to balance other taxable income, such as leasing income or capital profits, since it is regarded as a deductible expense. The precise effect of depreciation on a property owner’s tax obligation will vary depending on a number of variables, such as the age, worth, and condition of the property as well as the owner’s personal tax position. Property owners can better grasp the particular tax advantages of depreciation by working with an experienced accountant or tax expert, who can also make sure they are taking full advantage of all possible tax-saving opportunities.
Property depreciation is an important tax concept that real estate investors must be aware of. By understanding how depreciation works and how it can be used to your advantage, you can save money on your taxes and reinvest it into growing your business.
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Frequently Asked Questions:
According to the property’s nature and anticipated usable life, the IRS calculates the depreciation rate for real estate.
While business properties can depreciate over a 39-year span, residential properties can only do so over 27.5 years.
No, land is not a depreciable asset, as it is considered to have an infinite useful life.
The ability to subtract a part of the cost of their property from their taxed income each year thanks to real estate depreciation can help property owners lower their tax obligations.
No, real estate depreciation is a non-cash expenditure, which means that no currency needs to be spent in order to incur it. It is merely a method for property proprietors to take into consideration the normal deterioration of their building over time.
President of Saint Investment Group
Nic is a two decade seasoned expert in investing and capital raising, specializing in Real Estate and debt markets. With Saint Investment Group, he leads large-scale distressed asset purchases and innovative syndications for investors.