By Joel Snyder
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01 Nov, 2019
From income to price appreciation, a real estate investment is chock full of potential benefits related to appreciation. However, one of the most commonly overlooked, but equally as powerful, benefits is the favorable tax treatment created through depreciation. What is Depreciation? Just like any tangible asset, real estate tends to degrade over time. What was once a gleaming new property will slowly wear out, succumbing to things like weather, changing tastes, and degradation of major systems like HVAC, Electrical, and Plumbing. To account for this, the accounting rules that govern real estate allow for a gradual reduction in the value of the property in a process known as depreciation. Officially, depreciation is defined as the accounting method of allocating the cost of a tangible asset over its life expectancy. It represents how much of an asset’s value has been used up and is found as a line item on the income statement. , (1,2) Why It Matters Depreciation is beneficial because it’s recorded as an expense line item on the income statement, even though it doesn’t represent cash out of the owner’s pocket. Expensing depreciation reduces the taxable income of the property, creating a smaller tax bill in the process. Consider the following example: Property #1 - No Depreciation Property #2 - Depreciation Income $100,000 Income $100,000 Taxes $20,000 Taxes $20,000 Insurance $8,000 Insurance $8,000 Utilities $12,000 Utilities $12,000 Depreciation $10,000 Total Expenses $40,000 Total Expenses $50,000 Net Operating Income $60,000 Net Operating Income $50,000 Both properties have the same amount of income, but property #2 lists $10K in depreciation on the income statement. As a result, the taxable income is reduced by $10K. Assuming a tax rate of 25%, expensing depreciation results in a tax savings of $2,500. Perhaps this is an oversimplified example, but the savings can be significant on a larger scale. Calculating Depreciation With the benefit of depreciation established, the question becomes, “how is the annual depreciation amount calculated?” To answer the question, three inputs are required: ➢ Cost Basis: The Cost Basis establishes the starting point for expensing depreciation. More often than not, it’s the purchase price of the asset. ➢ Useful Life: The Useful Life is an estimate of the property’s functional lifespan. Per IRS rules, there are some required standards, but a safe estimate is 27.5 years for residential property and 39 years for commercial. (3) ➢ Depreciation Method: Per IRS guidelines, there are multiple allowable methods to depreciate a property, but the most common is the “straight line” method, which divides the cost basis by the property’s useful life. (1) Let’s put these inputs to work in an example. Assume a property with a $1MM purchase price, 39-year useful life, and straight-line depreciation method. In this scenario, the annual allowable depreciation would be $25,641 ($1MM/39). So, for every year an investor owns the property, they’ll be allowed to record this amount in depreciation expense, thereby reducing their taxable income. While this is great, there’s a hidden cost to be aware of. Depreciation Recapture If an investor has owned a property for a significant amount of time before selling it, there’s a hidden tax known as “Depreciation Recapture,” which is the tax that must be paid on the difference between the property’s sales price and cost basis. Using the same example from above, let’s assume the same investor who purchased the property for $1MM is going to sell it after their 10-year holding period. If $1MM was starting point and $25,641 in depreciation was taken annually, then the property’s cost basis at the end of 10 years is $743,590 (($1,000,000) - ($25,641*10)). Let’s also assume that at the end of the 10-year holding period, the property was sold for $1.2MM. Upon sale, the investor must pay taxes on the difference between the cost basis of the property ($743,590) and the sales price ($1,200,000). Assuming a 25% tax rate, taxes on the sale are going to be $114M. This can be a surprise for investors if it isn’t planned for and slightly offsets the benefits of expensing depreciation. What to Do When Depreciation Runs Out If a property has been held long enough for its cost basis to be reduced to $0, there may be a uniquely large tax bill associated with its disposition. In addition, the owner will no longer be able to reap the tax benefits of additional depreciation. So, they’ll likely consider doing one of three things: ➢ Nothing: An investor may choose to do nothing, which is fine, but their return on the property would likely be reduced since they’re no longer reaping the benefits of the depreciation expense. ➢ Sell The Property: The investor can dispose of the asset, but would face a hefty depreciation recapture tax in doing so. ➢ Exchange the property: Using a 1031 Exchange , an investor may sell the property and use the proceeds to buy a new property in a process known as a 1031 exchange. This option has two major benefits: (1) Taxes are deferred on the sale as long as the proceeds are invested into a property of “like kind;” and (2) The owner can start the depreciation process on the new property all over again. Summary & Conclusions Because it isn’t associated with direct returns on an investment, depreciation is an often overlooked benefit to real estate investing due to potential tax savings. To take advantage of it, it’s important to know the basics and to work with a qualified CPA to ensure that all required taxes are paid and that all allowable depreciation is taken. But, if a property is held for a long period of time, it’s important to account for the depreciation recapture tax, which can often catch investors by surprise and unprepared to pay it when the property is sold. I specialize in helping my clients identify and select 1031 Exchange properties or DST properties that are suitable for their risk tolerance and time horizon. If you are interested in learning more about replacement options and/or DST investment opportunities , I’d like to invite you to set an appointment or to attend our next seminar. You can do so by calling me at 650-282-0477 or by sending an email at amit@Get1031Properties.com. ______________________________________________________________________________ (1) Accounting rules allow for depreciation on the structure and improvements only. Not land. (2) Not to be taken as accounting advice. Always consult a qualified CPA who can provide advice relevant to your unique situation. (3) Always consult a CPA This is informational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Hypothetical examples are for illustration purposes only and individual results will very. There are risks associated with investing in real estate and Delaware Statutory Trust (DST) properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Get 1031 Properties is independent of CIS.