How the Real Magic Word in Real Estate, “Depreciation”, Impacts Your Tax Liabilities

If you are in any way exposed to the world of real estate investing, then you undoubtedly have heard investors mention the word “depreciation”. Most people have a negative connotation when they talk about depreciation, such as the loss of value of their personal vehicle. After all, a Mercedes that was worth north of $100,000 five years ago, can fetch no more than $40,000-$50,000 today.

In real estate investing it’s quite the opposite, and more often than not, it is the losses that are associated with depreciation that attract many investors. The beauty of depreciation and the losses it offers apply to both investor types; people that invest actively as well as people that invest in real estate passively.

Keep in mind that while depreciation offers tax deductions for real estate investors, the actual amount by which your taxes will be reduced is dependent on your tax bracket. So whether real estate is your active line of business and you claim real estate professional status, or you have a W2 job and can’t claim real estate professional status, will impact whether you may be able to claim losses against your ordinary income or passive gains only. Let’s dive into the definition of depreciation, break down different types of depreciation, and describe how it applies to different tax breaks for your type of investment.

While depreciation rules are fairly extensive, in general, it is a terrific tool that allows you to reduce your tax liabilities.

The details needed to calculate depreciation depend on a variety of complex factors, so let’s start with the basics. Firstly, the land on which the property is located is not depreciable, and therefore it cannot be deducted as an expense. Secondly, it is important to understand that the property is only eligible for depreciation expense if it is an investment. In other words, you can’t depreciate property if you use it 100% for personal purposes. To be eligible for depreciation expense, the property must be owned by an investor, who must hold it for longer than a year, and just as importantly it must be used to produce income.

Investors can deduct up to the entire cost basis of the property until the property is sold or converted for personal use.

I introduced a new term – “cost basis”, so let’s expand on what it means, and dive into specific examples.

Simply put, the main component of the cost basis is the purchase price that was paid for an investment property. This figure is important because, on a high level when an investment property is sold, the seller pays capital gains tax based on the difference between the amount for which the property sells and the original purchase value. In addition to the purchase price of the property, the cost basis may include such items as the legal costs associated with acquiring the property, as well as title insurance, taxes, and other expenses that are associated with closing on the purchase of the property. Depreciation is usually calculated by knowing the investor’s cost basis in the property as well as the time frame for which depreciation can be claimed (aka the property’s useful life). So, let’s use a specific example to explain these items. If let’s say, you purchase an apartment building for $2,000,000, you spend $50,000 in closing costs and you plan on making $300,000 worth of improvements, then your cost basis for this property is all of these expenses added up, or $2,350,000.

There is another important term you need to keep in mind; it is called “adjusted cost basis”. Your property’s adjusted cost basis is simply the difference between your property’s cost basis and the amount of cumulative depreciation taken so far.

The higher your adjusted basis is, the less you’ll pay in the way of capital gains tax when you sell and realize a profit.

We’ve come to the point where the depreciation topic becomes a bit more complex. As is the case with calculating your taxes in general, there is no straightforward way to calculate depreciation. In fact, there are several different depreciation methods, such as straight-line, declining balance, sum-of-the-years’ digits, and units of production. You should consider consulting with your CPA about which method is most beneficial for your specific investment.

Let’s expand on the example above to further lay out how to reduce taxable income on your property based on its depreciation expenses. In the example above we purchased a property for $2,000,000. Let’s say that the breakdown cost of the building was $1,755,000 and the land cost was $245,000. In general, residential properties are depreciated over 27.5 years, while commercial properties are depreciated over 39 years. Therefore, the depreciation expense is $1,755,000/39 years = $45,000.

Let’s assume the property is producing income from Cash Flow. Just to make it easy it’s 10% cash on cash return, or $175,500. So taxable income is equal to Income – Depreciation = $175,500 – $45,000 = $130,500. If you’re in the 35% tax bracket, then your tax is $130,500 × 35% = $45,675, and your cash flow after taxes is: $130,500 – $45,675 = $84,825.

Guess what! You just saved $15,750 in taxes, which we calculate by multiplying $45,000 (Depreciation) × 35% (your tax bracket). Where on Wall Street would you see such a huge tax saving?!

But we are not done yet!

Another huge tax saving is bonus depreciation.

Bonus depreciation is a tax expense that allows you to deduct a percentage of your property’s purchase price, and it must be taken in the year the property was placed in service. This percentage was increased by The Tax Cuts and Jobs Act (TCJA) from 50% to 100% for all properties placed in service after 9/27/2017 and until 1/1/2023. The TCJA law specifies that 2022 is the last year to take advantage of the 100% of bonus depreciation in 2023, and afterward, the percentage will start phasing out by 20% each year so that in 2023 you will be able to take 80% of the bonus depreciation on your investment property and so forth.

Keep in mind that while we try to simplify the rules around depreciation, the laws are still extremely complex. Don’t make any assumptions and always consult with your CPA or tax advisor about depreciation or other tax-related questions. This article intends to enhance your knowledge about depreciation so that you will realize it’s magic and start asking your CPA sophisticated questions.

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