How Does Depreciation Work for Real Estate?

Jul 06, 2022

Real estate is tricky and is usually treated much different than a typical business. This is just one Blog Post and Podcast Episode in an entire guide we put together on real estate taxes.

If you have not checked out our other content around real estate taxes, do so now by visiting: The Ultimate Guide to Real Estate Taxes

In this post we are going to specifically be talking about depreciation and how it has such an important role when it comes to rental properties.

One advantage of investing in real estate is that for many of the early years you will often have a positive cash flow but for tax purposes show a loss and this is due to depreciation. Who wouldn't want to be bringing in cash and not having to pay taxes on it?

What Parts of Rental Real Estate Can Be Depreciated?

Everything can be depreciated in a rental property investment except for raw land. This includes things like the building, flooring, appliances, sinks, driveways, landscaping, etc.

Basically you need to find the value of the raw land versus everything else. The goal is to assign as much value as possible to the building and improvements versus the land.

The IRS recommends you use the local property tax assessment to determine the land value but you can also use your own appraisal or replacement cost to determine values as well, just as long as you have a reasonable basis to back up the allocation.

What Is the Depreciable Life for a Real Estate Investment?

Generally stating you would depreciate a rental property over 27.5 years for residential or 39 years for nonresidential. With that being said, if you are able to breakdown certain parts of the property you can likely depreciate it sooner!

  • Personal Property: 5 or 7 Years
  • Land Improvements: 15 Years
  • Structure: 27.5 Years (Residential) or 39 Years (Nonresidential)

As you can see if you are able to pull certain costs of the property into land improvements and personal property, that allows you to depreciate the cost quicker which leads to less taxable income earlier in the investment.

This is something called cost segregation.

What Is a Cost Segregation Study?

As discussed, when a property is purchased, not only does it include a building structure, but it also includes all of its interior and exterior components. On average, 20% to 40% of those components fall into tax categories that can be written off much quicker than the building structure.

A Cost Segregation study dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27.5 or 39 years. The primary goal of a Cost Segregation study is to identify all property-related costs that can be depreciated over 5, 7 and 15 years. For example, certain electrical outlets that are dedicated to equipment such as appliances or computers should be depreciated over 5 years.

We did an entire Blog Post and Podcast Episode on this with a partner of ours that handles the entire cost segregation study process for you. Check that out and reach out to us using the form in the Blog Post if you would like an introduction to them.

Essentially the study will follow this process:

  1. Divide land between raw land and land improvements. The more you can get into land improvements means you can depreciate that over 15 years.
  2. Divide the building into structure and personal property. The more you can get into personal property means you can depreciate that over 5 to 7.
  3. The remaining structure items would depreciate over the typical 27.5 or 39 years and the raw land of course would not be able to be depreciated.

These studies are complicated so we definitely recommend working with a professional on them. Traditionally a cost segregation study is going to be most advantageous in multi-family and commercial properties than single family. 

What Is Bonus Depreciation?

With the Tax Cuts and Jobs Act bonus depreciation allows you to depreciate up to 100% of qualified property in the first year. Qualified property includes items that have a useful life of 20 years or less. When we look at the cost segregation study above, this is a great way to get even more depreciation in year 1 utilizing bonus depreciation for those items we were able to pull away from the "structure".

NOTE: This percentage goes down in future years. It turns into the following:

  • Placed in Service in 2022100%
  • Placed in Service in 2023: 80%
  • Placed in Service in 2024: 60%
  • Placed in Service in 2025: 40%
  • Placed in Service in 2026: 20%
  • Placed in Service in 2027: No Bonus Depreciation but Section 179 Expensing still available.

Rental Property Depreciation Example

I want to put this into practice, so lets go through a few assumptions:

  • Purchased a $500k multi-family rental in 2022
    • $100k Allocated to Land
    • $400k Allocated to Building

In this example, the $100k allocated to land we know it not able to be depreciated but traditionally the $400k related to the building we would depreciate over 27.5 years. This would be roughly $18,000 in depreciation per year.

Now lets assume you decided to do a cost segregation study and we were able to pull 30% of the building cost and move it into 5,7, or 15 year property. That would be $120,000. With 100% bonus depreciation available in 2022 we could potentially depreciation that full $120,000 in year 1 with the remaining $280,000 over 27.5 years.

First Year Depreciation: ~$18,000 vs ~$130,000 Using Cost Segregation Study + Bonus Depreciation 

One thing to note is that when/if you decide to sell an asset that has been depreciated you will need to pay a depreciation recapture tax. This means that although you get a great write-off from the depreciation you will potentially need to pay it back some day down the road. However, with the time value of money factored in, we would almost always recommend taking advantage of as much depreciation as possible. 

Again, this is just one Blog Post and Podcast Episode in an entire guide we put together on real estate taxes.

If you have not checked out our other content around real estate taxes, do so now by visiting: The Ultimate Guide to Real Estate Taxes

We also have a full section in our Tax Minimization Program specific to strategies around rental properties!

 

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