Depreciation is a key tax strategy for real estate investors, allowing them to reduce their taxable income without affecting their actual cash flow. Understanding and applying depreciation can significantly lower your tax bill and improve your investment returns.
What is Depreciation?
In simple terms, depreciation lets you write off the cost of a property over time. For residential properties, this period is typically 27.5 years. For example, if you buy a property and allocate $200,000 of its cost to improvements, you can depreciate $7,272 each year ($200,000 divided by 27.5 years).
- Allocate More to Building Value: Since land can’t be depreciated, aim to allocate a higher portion of the purchase price to the building, which is depreciable. Often, 20% is allocated to land and 80% to the building, but this can vary based on appraisals or property tax assessments.
- Cost Segregation Studies: These studies can reclassify certain property costs from a 39-year depreciation schedule to a shorter 5, 7, or 15-year schedule. This method can increase your near-term tax deductions significantly.
- 100% Bonus Depreciation: Under recent tax law changes, certain property aspects (like personal property or land improvements) can be fully depreciated in the first year of ownership, offering a substantial tax break.
Example of Depreciation Benefits
If you have a building worth $100,000, the typical annual depreciation would be $3,636. However, with cost segregation, you could potentially increase your first-year deduction to $22,909 by combining bonus and regular depreciation.
Be Aware of Depreciation Recapture
While depreciation lowers your tax liability during ownership, it’s important to consider depreciation recapture. This is a tax on the depreciation you claimed when you sell the property. For example, if you claimed $80,000 in depreciation over several years, and then sell the property, that $80,000 is taxed up to 25% as ordinary income.
Depreciation is a powerful tool in real estate investing, allowing investors to save significantly on taxes. However, it’s important to understand the rules and implications, including depreciation recapture. As always, consult with a tax professional to make the most of this strategy in your specific situation.
Disclaimer: This article is for educational purposes only and should not be construed as financial or investment advice