Accelerated depreciation is a method in which larger depreciation expenses are recognized in the early years of a project's life, and smaller expenses are recognized later. This method is often used for tax purposes, as it allows businesses to write off a larger portion of the cost of an asset in the year it is purchased.
Accelerated depreciation is generally available for commercial property used for business purposes, such as office buildings, warehouses, and manufacturing facilities. It is not available for personal property, such as homes or automobiles.
A real estate investor has two reasons for choosing to accelerate depreciation. First, accelerated depreciation deduction can be timed during a year when there's a higher-than-normal tax rate and there's a spike in the investor's ordinary income. Claiming a bigger depreciation expense will reduce the overall taxable income. Second, if it's possible to subtract the entire asset cost in the first year (or the first few years), the investor can have more money in his pocket due to the tax savings.
However, it's important to note that accelerated depreciation does not increase cash flow in the short term - it simply decreases taxable income.
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Residential buildings are depreciated over 27.5 years, while commercial properties take 39 years to depreciate. That can be a long period of smaller tax deductions. Accelerated depreciation allows real estate investors to gain the tax deduction early on when they've just purchased the property or made the improvements.
There are four ways to use accelerated depreciation as a tax-saving strategy.
Section 179 allows investors to write off a depreciation expense of up to $1,000,000 for the equipment or software they use in business. For 2022, that figure has been adjusted to account for inflation, which is now $1,080,000. Bonus depreciation is an additional depreciation amount that can be deducted from the property's gross income. For 2022, it is offered at 100% of the cost of asset purchases.
Qualified improvement property covers any improvements made to the interior of a commercial building after it was built and placed in service, such as drywall replacement, lighting upgrades, and plumbing repairs. These improvements can be qualified for bonus depreciation or depreciate the improvements using the straight-line method for 15 years.
When you buy a building, the entire property, along with any improvements and equipment, is lumped as one and follows the maximum required depreciation life. However, some property elements, like carpeting, fencing, and plumbing, may not last as long as the building and will need repairs along the way.
Cost segregation involves looking at each property element and splitting them into different categories. Doing so helps you benefit from accelerated depreciation on some of these components.
Another method to enjoy accelerated depreciation is through the 179D tax deduction. This benefit allows business owners to receive tax deductions for energy-efficient building improvements. Currently, you can claim $1.80 per square foot for the qualified building. If the building spent $100,000 on energy-efficiency improvements, there would be $180,000 in tax savings.
Accelerated depreciation is meant to give businesses and investors a stimulus and incentive for investing and upgrading their properties. With this method, you can enjoy tax relief in the year when a major asset was purchased, or a higher-than-normal income tax rate is expected.
However, a complex set of rules limits real estate investors' ability to take advantage of accelerated depreciation. You should always consult a professional tax adviser who can present detailed strategies for claiming accelerated depreciation. This will help you avoid any nasty surprises from the IRS.
Aside from substantial tax savings, accelerated depreciation works as a time-value-of-money strategy where the tax savings are reinvested into the venture to generate an even higher return.
If the concept of real estate depreciation intimidates you, but you want to experience the advantages of real estate investing, we suggest considering real estate funds. These are pooled funds invested in rental properties and managed by professional fund managers who'll take care of all operation aspects, ensuring you receive stable passive income while preserving and appreciating your capital.
Get in touch with Saint Investment to learn how to take advantage of this opportunity.
A master in Investment, Marketing, and Capital Raising.
Nic has honed his focus on the Real Estate and debt markets with Saint Investment Group and pursues large-scale Distressed Asset purchases with his partners and syndications.