The goal for most investors is for their asset’s value to appreciate, not decline, but in the context of real estate investment, depreciation is a powerful tax-saving tool that can significantly boost your cash flow and overall returns. Understanding how it works is important if you’re looking to maximize the financial benefits of your portfolio.
What is Real Estate Depreciation?
In accounting terms, depreciation is the process of allocating the cost of a tangible asset over its useful life.
The Internal Revenue Service (IRS) recognizes that buildings and their components wear out over time and allows investors to deduct this "wear and tear" from their taxable income - and you don't have to spend any money to claim it, which makes it a particularly valuable benefit for property owners.
However, only the structure or building itself can be depreciated, not the land it sits on. Land is not considered a depreciable asset because it does not have a finite useful life, so the first step in calculating depreciation is to separate the value of the building from the value of the land.
How to Calculate Depreciation
The most common method for depreciating residential rental properties is the Modified Accelerated Cost Recovery System (MACRS) whereby residential properties are depreciated over a "useful life" of 27.5 years, and commercial properties are depreciated over 39 years.
The calculation for annual depreciation is straightforward:
(Property Value – Land Value) ÷ Useful Life = Annual Depreciation Deduction
To simplify this process, a real estate depreciation calculator is a useful tool.
Why Depreciation Matters for New Investors
The main benefit of depreciation is the potential for significant tax savings when you invest in property, as it can lower your annual tax liability, which in turn increases your cash flow. This extra cash can be used for property improvements, like a new kitchen or roof, or reinvested into other assets, such as another property, or simply kept as profit to pay for your dream vacation.
Depreciation can also make a profitable investment appear as a loss on paper that can be used to offset other passive income, further reducing your tax burden. This is especially handy for investors in higher tax brackets.
Understanding Depreciation Recapture
While depreciation is a valuable tool when you own a property, it's essential to understand its implications when you decide to sell, as then the IRS will "recapture" the depreciation you've claimed over the years. This recaptured amount is taxed at a maximum rate of 25%, but savvy investors can utilize strategies like a 1031 exchange to defer these taxes by reinvesting the proceeds into a similar property.
Advanced Depreciation Strategies
For more experienced investors, there are advanced strategies to maximize depreciation benefits.
A cost segregation study, for example, identifies personal property components within a real estate asset that can be depreciated over a shorter period, typically 5, 7, or 15 years, rather than the standard 27.5 years for the entire building. This can lead to larger deductions in the early years of ownership.
Another strategy is bonus depreciation where investors take an additional deduction in the first year a qualifying asset is placed in service. The rules for this can change, but it has historically allowed for significant upfront deductions on certain property components with a shorter useful life.
Understanding and utilizing depreciation can save tax dollars, boost cash flow, and accelerate wealth building. As with any financial matter, it’s a smart idea to talk to a qualified tax professional to ensure you are maximizing the benefits of depreciation in accordance with IRS regulations.
