Some of the greatest advantages of investing in private real estate are its many tax benefits. Chief among them is the ability to take depreciation deductions, a tax advantage that can only be used on investment properties. It allows owners to dramatically reduce, or even eliminate, taxable income on rental profits.
But the rules on real estate depreciation tax benefits can get confusing. Real estate owners must be able to judge which ones will let them make the most of this tax benefit. Precisely for this reason, at Origin we evaluate every property on a case-by-case basis. Here are the fundamentals we consider for our properties to maximize the tax advantages the depreciation deduction offers investors.
Unlike the old adage about new cars—they lose 30% of their value the minute you drive them off the lot—in residential properties, depreciation works for investors instead of against them. Depreciation is the decline in a property’s value that occurs over its useful lifespan due to age, wear and tear, or decay. The U.S. tax code grants rental property owners depreciation deductions when paying taxes to allow them to recover the capital they have invested in a property to maintain it over time—even if the property produces positive cash flow.
However, to depreciate private real estate, a property must meet several conditions. An investor must own it for the purpose of generating income (whether it’s passive income or not); plan to hold it for more than a year; and be able to determine the property’s useful life, which is the lifespan of a property mandated by IRS code. The IRS allows investors to deduct depreciation for 27.5 years on a residential rental property and 39 years on a commercial property.
How much depreciation an investor can deduct each year is based on three things: the cost basis of a property, which is how much an investor paid for it; the property’s useful life (as mentioned above); and which method of depreciation is used. But cost basis is only a starting point in calculating depreciation; it’s also necessary to understand depreciable basis and adjusted cost basis.
Types of Cost Basis in a Rental Property
Here’s what to keep in mind:
Cost basis reflects everything spent to acquire and place a property in service, which includes the mortgage debt obtained to buy the property, all legal costs, debt that may have been assumed from the seller and fees for reports, surveys, transfer taxes, title insurance and so on. Any capital improvements that are made after the purchase of the property adds to the overall basis of the property. For example, let’s say we buy a property for $1 million and invest an additional $200,000 for capital improvements; the cost basis of the property is $1.2 million.
Depreciable basis is the basis that is actually used to calculate the annual depreciation deduction because it excludes a property’s land cost. Land is not a depreciable asset under the IRS Code because it is never used up, so it must be subtracted from a property’s purchase price. Let’s say in our example above that land accounts for $100,000. The depreciable basis is $1.1 million (the $1.2 million of cost basis less the cost of land).
Adjusted cost basis is one more figure to keep track of to determine depreciation. It accounts for events that occur over time to increase or reduce a property’s cost basis, such as capital improvements or general wear and tear. Adjusted basis is calculated by taking the property’s cost basis, adding improvement costs and related expenses, and subtracting deductions taken for depreciation or depletion. This figure is used to determine the capital gain or loss when a property is sold. Let’s say the depreciation deductions in the example above add up to $40,000 since inception. The adjusted cost basis would be $1,160,000 (the $1.2 million less the depreciation deduction of $40,000).
How is Depreciation Calculated?
The method that investors can use to determine their depreciation deductions depends on the life of the asset being depreciated and is set by the Internal Revenue Service’s Modified Accelerated Cost Recovery System (MACRS). Under these regulations, buildings are generally depreciated on what is effectively straight-line depreciation over the course of 27.5 or 39 years, depending on whether the property is residential or commercial. Straight-line depreciation spreads the value of the property evenly over its useful life.
The tax savings provided by depreciation can be substantial. It directly reduces an entity’s taxable income, resulting in lower taxes and higher after-tax cash flow. This is called depreciation expense, or the portion of a fixed asset that has been considered consumed in a current period and can be charged as an expense.
Here’s an example of how it works. Let’s say an investor buys a residential rental property for $1,000,000. If the land value is $175,000 and the cost of the building is $825,000, the annual depreciation would be $30,000 ($825,000/27.5). In this example, let’s assume that the property yields a 5% cash return that amounts to $50,000. Unlike stock dividends, which are fully taxable in the year of receipt, the income from a rental property is substantially shielded from taxation by depreciation, providing real potential for investors to enjoy a highly tax-efficient stream of income for years, as Table 1 below shows.
Table 1: How Annual Savings from Depreciation Works
|Cash From Rental Operations
|Tax @ 37%
|Post-Tax Cash Flow
|Annual Tax Savings ($30,000 x 37%)
In the example above, we considered depreciation on building that has a tax-life of 27.5 years. For assets with a useful life of 20 years or less, MACRS provides specific direction to calculate the exact depreciation expense for a given year, which includes accelerated depreciation for certain capital improvements such as landscaping, fences, sidewalks, etc.
Additionally, recent tax code changes offer “bonus depreciation” for qualified property in the year it is put into service, allowing investors to deduct any applicable large capital expenditures at once. Bonus depreciation can offer huge tax-savings potential and can be used on property improvements that relate to rentals – from landscaping to expensive fixtures and appliances.
How Does Depreciation Impact a Sale for Investors?
While depreciation works for investors when they own a property, it works against them when they sell it. That’s because taking depreciation deductions reduces the cost basis of the property, often resulting in higher gains when a property is sold. Those gains are taxable and are subject to depreciation recapture, which allows the IRS to collect taxes on the deductions the property owner had used to previously offset taxable income.
Depreciation recapture is assessed when a property that has been depreciated is sold and the sale price exceeds its adjusted cost basis—in other words, when the sale of a property results in a taxable gain. The tax characteristic of depreciation recapture can be either ordinary income or capital gains, and will depend on the type of property that was sold – was it a section 1245 property or a section 1250 property? At a high-level, section 1245 property includes tangible personal property such as office equipment or furniture that is subject to depreciation, or intangible personal property such as patents that are subject amortization. Section 1250 property most commonly consists of depreciable real property, such as residential rental buildings.
When a section 1250 property is sold for a gain, that gain to the extent of depreciation the owner deducted annually, is subject to taxes at a maximum rate of 25%. This is commonly referred to in tax accounting as unrecaptured section 1250 gains. For investors in a high tax bracket, the 25% cap on the recapture rate is a silver lining as they are likely to have enjoyed depreciation deductions during the hold period at their ordinary income tax rates, which can be as high as 37%.
Here’s an example of how this works. Let’s assume that an investor sells the asset for $2,000,000 after 10 years. Remember that the investor has claimed depreciation of $30,000 a year using the straight-line method. In this case, the taxable gain on the sale is allocated to two tax categories: Unrecaptured section 1250 gains that are taxed at 25%, and section 1231 gains that are taxed at the preferential long term capital gains rate which varies according to an investors tax rate.
The example in Table 2 illustrates how this works when a property is sold. The depreciation recapture shown below is subject to a tax rate of 25%, yet the investor deducted depreciation at 37% annually over the 10-year hold period. As a result, the investor has enjoyed a net tax savings of $36,000.
Table 2: How Depreciation is Calculated at Sale
|Original Cost of Property
|Less: Depreciation Deductions From Years 1 to 10
|Less: Adjusted Basis
|Taxable Gain on Sale; Categorized as Below
|Unrecaptured Section 1250 Gain (Taxed at 25%)
|Section 1231 gains (Taxed at Long Term Capital Gains Rate)
Table 2 above shows the impact of depreciation recapture when real property (section 1250 property) has been depreciated on a straight-line basis. While this is the most common scenario, depreciation taken on tangible personal property (section 1245 property) can change the equation. The gain on the sale of tangible personal property to the extent of any depreciation (including bonus depreciation and section 179 depreciation, which is generally limited to tangible personal property used for business) will be taxed as ordinary income—not capital gains. This is called Section 1245 recapture.
Table 3: Overall Tax Savings from Deprecation
|Straight Line Depreciation During Hold Period: Years 1 to 10
|Tax Savings on Above (37% of $300,000)
|Recapture Tax Paid at Sale (25% on $300,000)
|Net Savings in Taxes from Depreciation
*Assumes the investor is in the highest federal income tax bracket
How to Know Which Depreciation Deductions to Take
Investors must evaluate which depreciation method makes the most of the benefits each one offers. For instance, the difference between straight-line and accelerated depreciation shows certain aspects of a rental property business, such as qualified capital improvements, can depreciate faster, providing potential for huge upfront tax savings. However, investors who make use of such accelerated depreciation techniques must do so in conjunction with its tax impact on the business interest deduction—a deduction for the cost of interest on any loans used to maintain a business’s operations or pay its expenses.
At Origin, we evaluate each property we acquire to decide which methods of depreciation offer our investors the greatest benefits. Since Origin properties are in funds to reduce risk and increase returns, the determining factors we use include the hold period of the assets, tax rates, overall gains generated from other Origin assets, fund structure and the impact of acceleration on interest deductibility.
While depreciation is one of the most advantageous tax benefits of real estate investing, investors can still face a significant tax bill when they sell a property—especially after depreciating it for years. That’s where effective tax planning measures can help, such as Qualified Opportunity Zone investments, which can offer investors a way to defer and shield tax payment on capital gains and unrecaptured section 1250 gains well into the future.
Note: Please consult with your tax advisor for the most up-to-date information regarding tax consequences when investing in real estate.