Depreciation and Accelerated Depreciation in Real Estate  (2022)

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Depreciation and Accelerated Depreciation Allow Real Estate Investors to Take Significant Tax Deductions

Investing in multifamily and commercial real estate has a variety of incredible tax benefits-- and the ability to take depreciation deductions is one of them. Physical items, including real estate, degrade and become less valuable over time, so the IRS allows investors to deduct the cost of that degradation from their overall income on an annual basis, reducing their overall tax burden.

There are multiple types of depreciation; the major types relevant to commercial real estate investors include straight-line depreciation, accelerated depreciation, and bonus depreciation.

Straight-line depreciation is the simplest type of depreciation and is typically utilized by taking an equal tax deduction each year until the building is fully depreciated. Accelerated depreciation allows investors to take their depreciation deductions on a faster, or “accelerated” schedule, typically by ordering a cost segregation study. Bonus depreciation is a specialized type of depreciation that allows investors to take an even larger deduction over a 1-year period, sometimes up to 100% of the improved value of the property.

Straight-Line Depreciation Allows Real Estate Investors to Take Long-Term Depreciation Deductions

As previously mentioned, straight-line depreciation is the most simple form of depreciation. Non-multifamily commercial real estate can be depreciated over 39 years, while multifamily real estate can be depreciated over a 27.5-year period.

Depreciation and Accelerated Depreciation in Real Estate (1)

(Video) Cost Segregation Real Estate (BIG Advantages of Accelerated Depreciation!)

When it comes to taking depreciation deductions, the value of the land cannot be incorporated into the depreciation dedication. Instead, only “land improvements” are counted. This includes both the building itself and other land improvements, including driveways, parking lots, carports, paved areas, curbing walkways, sidewalks, site utilities, concrete stairs, fencing, block walls retaining walls, and even dumpster enclosures.

For example, if an investor purchases an apartment building for $20 million, and the base land is worth $2 million, they would only be able to take depreciation deductions on $18 million ($20 million - $2 million). Because multifamily properties are depreciated on a 27.5-year schedule, the investor can take an equal portion of depreciation deductions each year for each of the next 27.5 years ($18 million/27.5). This would equal approximately $650,000 in deductions per year.

It should be noted that, in addition to the purchase price of the property, certain closing costs can also be depreciated. Some depreciable closing costs include:

  • Legal fees

  • Title insurance

  • Surveys

  • Transfer taxes

  • Abstract fees

  • Utility installation service charges

  • Recording fees

It should also be noted that landscaping can also be depreciated, and can be segregated into different elements like tress, much, plants, and sod.

Accelerated Depreciation Allows Investors To Take Depreciation Deductions Faster

While straight-line depreciation is a great way for investors to lower their tax burden, it isn’t always the best way. While the IRS posits that buildings themselves depreciate over 27.5 or 39-year schedules, they admit that some building elements degrade faster. For example, you may need to replace an apartment building’s roof every 15 years. Therefore, they allow you to take depreciation deductions for these building components faster, in a process that’s called accelerated depreciation. Building components eligible for accelerated depreciation can usually typically be depreciated on a 5,7, or 15-year schedule.

If we take the same example from the straight-line depreciation section, and say, for instance, that 20% of the building could be depreciated on a 5-year schedule instead of a 27.5-year schedule, this would mean that an investor could take approximately $720,000 per year of additional depreciation deductions for that 5-year period. To compensate, the core straight-line depreciation amount would go down, but this would still significantly increase the velocity of tax deductions an investor would receive.

Unfortunately, however, if you’re an investor, the IRS is not simply going to take your word about how fast you think your building components are depreciating. Therefore, to take accelerated depreciation deductions, investors generally need to hire an engineering inspection firm to conduct something called a cost segregation study.

(Video) Real Estate Tax Deductions, Accelerated Depreciation, Tax Strategies for Real Estate Investors !

Bonus Depreciation Allows Investors To Take Up To 100% of Their Depreciation Deductions in One Year

Bonus Depreciation is a specialized form of accelerated depreciation permitted by the Tax Cuts and Jobs Act of 2017. Instead of permitting property owners to take relatively small depreciation deductions each year, it permits them to take 100% of the property’s improved value as an income tax deduction in one year. However, Bonus Depreciation won’t last forever-- it only applies to properties acquired by the end of 2022, so if investors want to take advantage of this opportunity, they should try to act fast.

Using a Cost Segregation Study to Take Accelerated Depreciation Deductions

To begin the process of getting a cost segregation study, an investor should contact and get quotes from several reputable cost segregation firms. A cost segregation study is not necessarily worth it for every situation, so if this is the case, a quality firm will generally tell the investor this. In general, the most ideal time to conduct a cost segregation study is in the year the building is built, purchased, or rehabbed.

Despite this, investors can have a “look-back” study conducted at any time and claim the resulting write-offs without changing their previous tax returns. If an investor has not held a building for a long time and planning to sell the building quickly, it may not be worth getting a cost segregation study, though there are always exceptions.

When it comes to choosing a firm, reputation is everything, because a poorly done study could lead to serious issues if an investor is ever audited by the IRS. A high-quality firm will not only do good work but will stand by their study and be available to speak with the IRS to defend their study should an audit occur or any other questions arise.

Investors may want to make sure that any engineer they hire to conduct a cost segregation study is certified by the American Society of Cost Segregation Professionals (ASCSP). An ASCSP-certified engineer will have a CCSP designation after their name and indicates they have gone through a well-regarded certification and training process.

The Length and Cost of Cost Segregation Studies

In general, cost segregation studies take 45-60 days to complete, depending on how quickly the inspection firm receives information from the owner/investor.

(Video) Accelerated Depreciation & The Real Estate Investor

Cost segregation studies can vary in cost based on multiple factors, including building type, building size, and other considerations. Studies generally cost between $5,000 to $15,000, with higher fees for larger buildings, buildings with more tenants, lots of deferred maintenance, or unique structural complexities.

Depreciation Recapture: Paying Back The IRS

While depreciation is an amazing way for real estate investors to save money now, all great things must eventually come to an end, and depreciation (including accelerated depreciation) is no different. When an investor sells the property they took depreciation deductions on, they will need to pay the IRS back, in a process called depreciation recapture. However, money now is still far more valuable than money later, so taking these deductions is still highly valuable from a financial perspective.

Investors only need to pay the IRS back, however, if they sell the property for more than the “adjusted cost basis.” The adjusted cost basis is calculated by taking the original property cost and subtracting any depreciation deductions.

Depreciation and Accelerated Depreciation in Real Estate (2)

For example, if we take the example from the beginning of this article, if the investor sold the property after 5 years for more than $20 million minus depreciation deductions (let’s say these are 2.5 million), they would need to pay taxes based on the proceeds of the sale using their regular income tax rate, instead of the capital gains tax rate.

This isn’t ideal for investors, due to the fact the highest income tax rate bracket, as of 2022, is 37% for individuals earning $539,900 or more, compared to the highest capital gains tax rate is 20% for individuals earning $445,851 or more. These numbers are slightly different for married couples filing jointly, married couples filing separately, or individuals who are the “head of household.”

Therefore, continuing the example, if the investor sells the property for any more than $17.5 million, they would need to pay around $6.47 million on the property, assuming they can’t take any other tax deductions upon sale. However, there is a workaround, which we’ll mention next.

1031 Exchanges and Cost Segregation

If an investor is selling a commercial or multifamily property on which they have taken depreciation deductions and wishes to purchase a similar property of equal or greater value, they can utilize a 1031 exchange to defer their tax burden until the sale of the new property.

In fact, they can actually use another 1031 exchange to defer the taxes of the sale of that property as well. Some investors continue to “roll” new properties into 1031 exchanges for decades, or even their entire lives.

If you’re an investor and plan to do this, you should consider attempting to find a cost segregation firm with specific experience in 1031 exchanges. You will also want to work with a specialized 1031 exchange firm to help you with the process, as it can be complex, and involves a variety of specific rules and timelines that can be foreign to even the most experienced investors.

(Video) Depreciation Recapture Explained [Tax Smart Daily 007]

Other Common Tax Benefits for Multifamily and Commercial Real Estate Investors

While taking deprecation and accelerated depreciation deductions is typically one of the best tax moves an investor can make, it’s far from the only tax benefit offered by multifamily and commercial real estate investing. Other common tax benefits include:

  • Travel, Repairs, Maintenance Deductions: Inventors can generally take maintenance and repair costs, and travel to and from their properties (including hotel expenses and 50% of food and beverage costs) as deductions in the year in which these expenses are accrued. They may also be able to take deductions one education and event costs, such as attending seminars. Regular property improvements, however, need to be depreciated on their regular (or accelerated) schedule.

  • Real Estate Tax Loss Deductions: In the case that an investor actually loses money on a property and sells it at a loss, they can sometimes take a part of these losses as a tax dedication. This particularly applies to small investors making less than $100,000-$150,000 per year.

  • Mortgage Interest Deductions: Investors are allowed to take 100% of the interest they pay on their mortgage as a tax deduction. For example, if an investor had a $20,000/month mortgage, $7,000 of which was interest, they would be able to take $84,000 in tax deductions for that year.

  • IRAs for Real Estate Investment: If an investor utilizes a self-directed IRA for real estate investing, and sells a property after their required minimum age (generally 72) they will only pay income taxes, not capital gains taxes, on the property’s sale.

  • Qualified Business Income (QBI) Deductions: QBI deductions are a different type of dedication investors can take for passive income generated by real estate investments. The rules are extremely complex, so investors should check with a real estate accountant to learn more.

  • LIHTC and NMTC Programs: For larger real estate investors interested in affordable housing investment, the federal government’s LIHTC (Low-Income Housing Tax Credit) program permits investors in qualified low-income properties to take a 1:1 dollar deduction against their federal income taxes. Other similar tax credit programs include the New Market Tax Credits (NMTC) and Historic Tax Credit (HTC) programs.

  • Beneficiary Tax Deductions: If you plan to pass on commercial real estate to your heirs, your heirs will only pay taxes on the purchase price of the property, not its increased value. So, if you buy the apartment building in our previous examples for $20 million, and the value goes up to $40 million over a 15-20 year period (or less), your heirs will only pay taxes on the $20 million if and when they sell the property.

  • Opportunity Zones: The Opportunity Zones program is another part of the Tax Cuts and Jobs Act of 2017. It allows investors in real estate and small businesses who invest in low-income communities designed as official “Opportunity Zones” to defer their capital gains until December 31, 2026. However, to do this, they must either create or invest in an existing opportunity fund, a financial instrument that places 90% of its assets in commercial real estate or qualified businesses inside an Opportunity Zone. There are other benefits, including additional capital gains tax basis deductions, for investors who hold their investment for between 5-7 years.

In Conclusion: Depreciation is One of The Most Powerful Tax Tools For Real Estate Investors

No matter what type of depreciation deductions you take, as a real estate investor, depreciation is one of the most powerful tools to reduce your tax burden, increase your income, and enhance your ability to continue investing in real estate. However, depreciation rules, as with all tax policies, can be complex, which is why it’s essential to hire a qualified CPA with extensive real estate experience and other relevant professionals (such as 1031 advisors or cost segregation specialists) in order to guide you through the process. This way, you can maximize your potential deductions as well as prevent any mistakes or mishaps that could cost you financially, legally, or reputationally.

(Video) What Is Cost Segregation? [Accelerated Depreciation And How It Works]

FAQs

What is accelerated depreciation? ›

Accelerated depreciation is any depreciation method that allows for the recognition of higher depreciation expenses during the earlier years. The key accelerated depreciation methods include double-declining balance and sum of the years' digits (SYD).

What is the difference between accelerated and straight line depreciation? ›

While calculating depreciation in a straight line spreads its cost evenly over the course of an asset's life, accelerated depreciation allows for higher expenses to be deducted in the first few years after the asset purchase, lowering the expenses as the asset ages.

When can you do accelerated depreciation? ›

The Internal Revenue Service (IRS) allows building owners this opportunity for accelerated depreciation by utilizing the Modified Accelerated Cost Recovery System (MACRS) to depreciate certain land improvements and personal property over shorter life than 39 or 27.5 years.

What items qualify for accelerated depreciation? ›

How bonus depreciation works
  • Property that has a useful life of 20 years or less. This includes vehicles, equipment, furniture and fixtures, and machinery. ...
  • Qualified improvement property. ...
  • Computer software.
  • Some listed property. ...
  • Costs of qualified film or television productions and qualified live theatrical productions.
3 Nov 2020

What is accelerated depreciation in real estate? ›

Accelerated depreciation is a strategy that allows for a greater depreciation value in the earlier years of an asset's life. What this means in regards to real estate is that you can depreciate fixtures and moveable assets within the property (eg. appliances) faster than the useful life of the property.

What is the benefit of accelerated depreciation? ›

Who benefits? Accelerated depreciation is one of the largest corporate subsidies in the tax code. It allows taxpayers to take bigger deductions, and therefore pay smaller tax bills, in the earlier years of an investment. Accelerated depreciation therefore subsidizes business investments.

Can you switch from accelerated depreciation to straight-line? ›

The switch to straight line is automatic and there is no option to turn this feature off for assets using ACRS or MACRS method. To disable this feature for assets not using ACRS/MACRS: Go to Setup while in the Asset List window.

Which depreciation method is best for tax purposes? ›

The Straight-Line Method

This method is also the simplest way to calculate depreciation. It results in fewer errors, is the most consistent method, and transitions well from company-prepared statements to tax returns.

Can I take accelerated depreciation on rental property? ›

Accelerated depreciation on rental property is a strategy used to front-load depreciation expenses during the first few years of ownership. An investor may free up more cash for other uses by claiming accelerated depreciation, such as making improvements to increase rental income.

What is real estate depreciation? ›

Real Estate Depreciation

Depreciation is the process used to deduct the costs of buying and improving a rental property. Rather than taking one large deduction in the year you buy (or improve) the property, depreciation distributes the deduction across the useful life of the property.

Can I depreciate my rental property faster? ›

The IRS allows you to depreciate some improvements made to your rental property faster than 27.5 years.

What is 7 year property for depreciation? ›

Class life is the number of years over which an asset can be depreciated. The tax law has defined a specific class life for each type of asset. Real Property is 39 year property, office furniture is 7 year property and autos and trucks are 5 year property.

When can you start depreciating a rental property? ›

You start taking depreciation deductions not when you buy it but when you begin using the property to generate rental income. The IRS refers to this as putting the property "in service." Depreciation continues until one of two things happens: You have deducted your entire "cost basis" in the property.

Can real estate depreciation offset capital gains? ›

Depreciation does not offset the gain; it can actually increase the amount of capital gains realized on the sale of property.

How does real estate maximize depreciation? ›

Whether you rent it out or occupy it by your business, here's how you can maximize your real estate depreciation deduction.
  1. Segregate Personal Property from Buildings. ...
  2. Carve Out Improvements from Land. ...
  3. Convert Land into a Deductible Asset. ...
  4. More Limits and Considerations.

What is meant by depreciation? ›

The term depreciation refers to an accounting method used to allocate the cost of a tangible or physical asset over its useful life. Depreciation represents how much of an asset's value has been used. It allows companies to earn revenue from the assets they own by paying for them over a certain period of time.

How does accelerated depreciation affect income taxes? ›

Accelerating depreciation allows a business to write off the total cost of an asset over a faster time period than non-accelerated depreciation. Taking additional depreciation in a tax year means more expenses, which means a lower tax bill.

Do companies prefer straight-line or accelerated depreciation? ›

It is better to take income tax savings earlier in the life of an asset. Straight-line depreciation is easier to calculate and looks better for a company's financial statements. This is because accelerated depreciation shows less profit in the early years of asset acquisition.

What are 2 different types of depreciation? ›

What Are the Different Ways to Calculate Depreciation?
  • Depreciation accounts for decreases in the value of a company's assets over time. ...
  • The four depreciation methods include straight-line, declining balance, sum-of-the-years' digits, and units of production.

What are the 2 methods of depreciation? ›

Methods of Depreciation and How to Calculate Depreciation

Some of the methods for calculating depreciation are: Straight-line method. Written down Value method.

What are the 5 depreciation methods? ›

Companies depreciate assets using these five methods: straight-line, declining balance, double-declining balance, units of production, and sum-of-years digits.

Does GAAP allow accelerated depreciation? ›

Depreciation

These accelerated tax methods of depreciation do not comply with GAAP reporting rules, as outlined in FASB ASC Topic 740.

Does accelerated depreciation result in less taxes? ›

Therefore, under accelerated depreciation, an asset faces greater deductions in its value in the earlier years than in the later years. Accelerated depreciation is often used as a tax-reduction strategy.

How is accelerated depreciation calculated? ›

The sum of the years' digits method derives a depreciation rate from the expected life of an asset. To use it, sum up the digits for each year. For an asset with a useful life of four years, the calculation would be 4+3+2+1 = 10.

Should you depreciate a rental property? ›

In short, you are not legally required to depreciate rental property. However, choosing not to depreciate rental property is a massive financial mistake. It's the equivalent of pouring a percentage of your rental property profits down the drain.

How do I calculate depreciation on property taxes? ›

To calculate the annual amount of depreciation on a property, you divide the cost basis by the property's useful life. In our example, let's use our existing cost basis of $206,000 and divide by the GDS life span of 27.5 years. It works out to being able to deduct $7,490.91 per year or 3.6% of the loan amount.

Does depreciation count as income? ›

In accounting, accumulated depreciation is recorded as a credit over the asset's useful life. When an asset is sold or retired, accumulated depreciation is marked as a debit against the asset's credit value. It does not impact net income.

What happens to depreciation when you sell a rental property? ›

Real estate investors use the depreciation expense to reduce taxable net income during the time they own a rental property. When the property is sold, the total depreciation expense claimed is taxed as regular income up to a rate of 25%.

How do I calculate depreciation on a rental property? ›

To calculate depreciation on rental property, you need to figure out your adjusted basis. Adjusted basis is the cost adjustment you make to the cost of your property before you put it to rental use. After that, you divide the value by 27.5 years to arrive at your annual depreciation for your rental property.

How do you deduct depreciation on a rental property? ›

You can recover some or all of your improvements by using Form 4562 to report depreciation beginning in the year your rental property is first placed in service, and beginning in any year you make an improvement or add furnishings. Only a percentage of these expenses are deductible in the year they are incurred.

What are the types of depreciation in real estate? ›

  • • There are three categories (causes) of depreciation: Physical deterioration (curable or incurable);
  • Functional obsolescence (curable or incurable); Economic obsolescence (usually incurable)
  • subject property, and indirectly, from similar properties.

What causes real estate depreciation? ›

Depreciation itself is a loss in the existing use value of the property. It can be caused by physical deterioration or by functional or aesthetic obsolescence. While obsolescence is one cause of depreciation, such a decline in utility is not directly related to physical usage or the passage of time (Baum, 1991).

Is real estate a depreciating asset? ›

The house itself, the physical structure that you built or bought, is a depreciating asset, just like a car. It will age and fall apart over time unless you are constantly pumping money into it for maintenance. And the costs of maintenance and repair are expenses.

How do you avoid depreciation recapture on rental property? ›

One of the best ways is to use a 1031 exchange, which references Section 1031 of the IRS tax code. This may help you avoid depreciation recapture and any capital gains taxes that might apply.

How long can you claim depreciation on an investment property? ›

Can you still claim depreciation for your rental property after living in it? You can claim depreciation on your investment property after you lived in it, but the length of time you can depreciate it does change. The time you lived in it counts towards the forty-year lifespan of capital works deductions.

Do you pay back depreciation on rental property? ›

If you decide to sell your rental property for more than its current depreciated value, you will be required to pay what is referred to as the depreciation recapture tax. Essentially, this amounts to a 25 percent tax on the amount above depreciation value that your property sells for.

What is the bonus depreciation for 2022? ›

A big tax benefit from 2017's TCJA begins phasing out at the end of 2022. The 100% bonus depreciation will phase out after 2022, with qualifying property getting only an 80% bonus deduction in 2023 and less in later years.

Do companies prefer straight-line or accelerated depreciation? ›

It is better to take income tax savings earlier in the life of an asset. Straight-line depreciation is easier to calculate and looks better for a company's financial statements. This is because accelerated depreciation shows less profit in the early years of asset acquisition.

How do you find accelerated depreciation? ›

Popular Accelerated Depreciation Methods
  1. Double declining balance method: Double declining balance = 2 x Straight-line depreciation rate x Book value at the beginning of the year.
  2. Sum of the years' digits method: Applicable percentage (%) = Number of years of estimated life remaining at the beginning of the year / SYD.
25 Feb 2022

Is accelerated depreciation the same as impairment? ›

The amount of depreciation taken each accounting period is based on a predetermined schedule using either straight line or one of multiple accelerated depreciation methods. Depreciation differs from impairment, which is recorded as the result of a one-time or unusual drop in the market value of an asset.

Can you take bonus depreciation on real estate? ›

Bonus depreciation in real estate allows an investor to deduct the full cost of capital improvements in the same tax year the expense is incurred. Bonus depreciation currently is 100% but is scheduled to be phased out by the end of the 2026 tax year.

What is the 100% bonus depreciation? ›

In other instances, investors can take declining balance appreciation, in which they depreciate assets based on their remaining useful life. And then there's 100 percent bonus depreciation, in which the owner immediately deducts the entire expense.

Does rental property qualify for bonus depreciation? ›

You can apply bonus depreciation for an asset you use only part of the time in your rental activity. However, you must use listed property (primarily cars and light trucks) over 50% of the time.

Which depreciation method is best? ›

Straight-Line Method: This is the most commonly used method for calculating depreciation.

Can you switch from accelerated depreciation to straight-line? ›

The switch to straight line is automatic and there is no option to turn this feature off for assets using ACRS or MACRS method. To disable this feature for assets not using ACRS/MACRS: Go to Setup while in the Asset List window.

What is real estate depreciation? ›

Real Estate Depreciation

Depreciation is the process used to deduct the costs of buying and improving a rental property. Rather than taking one large deduction in the year you buy (or improve) the property, depreciation distributes the deduction across the useful life of the property.

Can you take accelerate depreciation on rental property? ›

Accelerated depreciation on rental property is a strategy used to front-load depreciation expenses during the first few years of ownership. An investor may free up more cash for other uses by claiming accelerated depreciation, such as making improvements to increase rental income.

Which of the following is not an accelerated depreciation method? ›

Which one of the following is not an accelerated depreciation method? Double-declining-balance method.

What is difference between depreciation and impairment? ›

Depreciation schedules allow for a set distribution of the reduction of an asset's value over its lifetime, unlike impairment, which accounts for an unusual and drastic drop in the fair value of an asset. For instance: A tractor depreciates in value from year to year throughout its useful lifetime.

Can you use two different depreciation methods? ›

Thus, a company can have two completely different depreciation methods, calculations and numbers on its books and in its tax returns, particularly if IRS rules dictate that a certain machine has a useful life longer than what the company plans to use it for.

Videos

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