Unlike stocks, bonds, and other financial products, commercial real estate is known for the variety of tax benefits it can offer investors. From accelerated depreciation to mortgage interest deductions and tax advantages for an investor’s heirs, these benefits can lead to a massive difference in returns, especially over an extended period of time.
Similar to any other physical asset, any asset in the commercial real estate market will completely wear down with time. Given this, investors have the option to deduct some amount from their income taxes every year owing to this reason. For now, the government does have the option to depreciate every commercial property for over 30 years and residential properties for over 20 years.
For prolonged depreciation deductions, investors can also look at some other options to make the most of the depreciation value. In several scenarios, investors can reach out to engineering firms to perform a thorough depreciation study, where they will check the different parts of the property and identify smaller parts that are eligible for shorter depreciation time. While this form of cost segregation can be applied to both commercial and multifamily properties, it is ideal for multifamily properties.
Does bonus depreciation have an impact?
A cost segregation study can help accelerate the depreciation; investors can also opt for quicker forms of depreciation, such as bonus depreciation. As per the new tax regulations, several investors opt for 100 percent of the property’s value to be deducted from depreciation in their very first year of ownership, up to 2025.
Recapturing depreciation
Given that depreciation has multiple benefits, investors will go back to legal authorities when they decide to sell their property, projected as recapturing depreciation. So how is the depreciation recapture triggered? It is triggered when a property owner decides to sell their property for the adjusted cost basis of property, which includes the original cost minus the cost of the property and any depreciation deduction that the owner has availed.
For example, if the owner decides to sell their property after ten years for over 5 million dollars (calculated by considering the original price, 6 million dollars, minus the depreciation received for 1 million dollars), this is when the depreciation recapture will be triggered. Due to this situation, the property owner will have to pay income tax regularly on the sale amount of the property rather than the tax rate for capital gains, which is quite less.
Commercial buildings begin depreciating the minute you acquire them. The asset may not be physically depreciating in terms of its usability or aesthetics, but every day, the building gets older, it becomes less valuable. Depreciation may be one of the most well-known tax benefits in commercial real estate. It is a non-cash expense, meaning you get a write-off each year but do not have to spend any money to get it. The IRS determines the useful life– the expected operating life– of a commercial real estate investment based on factors such as the condition of the property and changes that affect the asset’s economic usefulness, though there are other items and calculations that affect the calculation of depreciation.
With depreciation, the value of a property is depreciated over the amount of time determined by the IRS. For example, if the IRS determines an investment has a useful life of 39 years, you would be able to write off 1/39 of the property’s value as a depreciation deduction. There are limits to depreciation, however. Using the previous example, once the 39 years are up, you cannot continue to depreciate the property.
Depreciation is written off against ordinary income, so the amount of taxes paid on cash flow generated from the property is potentially reduced each year. When it comes time to sell the property, however, you will likely have to deal with depreciation recapture. This means you will have to pay taxes on the amount you depreciated while you owned the property. Fortunately, the tax rate for depreciation recapture is usually less than the income tax rate. The amount you save in taxes each year with the depreciation tax deduction will likely outweigh the tax bill for depreciation recapture.
How is Depreciation Calculated?
Once investors have determined that their property is eligible for depreciation, they will need to understand how to calculate depreciation deductions.
Depreciation is determined by the investor’s basis in the property, the recovery period (the time period for which the depreciation is being claimed), and the depreciation method used. Since 1986, depreciation has been calculated using the Modified Accelerated Cost Recovery System (MACRS), an accounting system that amortizes costs and deducted depreciation over 27.5 years for a residential asset and 39 years for a commercial asset; the span of a property’s useful life, as defined by the IRS. Using MACRS, with the help of a qualified tax account, investors can ascertain the cost of the property and separate the cost of land from the cost of buildings to calculate their basis in the property, determining an adjusted basis if necessary.
A tax accountant will also help investors figure out whether the General Depreciation System (GDS) or the Alternative Depreciation System (ADS) MACRS applies to the property, although in most cases the GDS is used. Once that system is determined, the recovery period can be calculated, applying a certain percentage for each year the property was in service.
How much will depreciation affect my taxes?
Rental property investors can include depreciation as one of the expenses on Schedule E when they file their yearly taxes. The tax liability will be reduced according to which tax bracket the investor is in. That percentage will determine the amount of the deduction.
Depreciation can help investors by spreading out the purchase price of a property over a number of years and allowing them to claim deductions during each of those years. It is less of a wealth-building strategy than a means for offsetting investment losses.
The IRS does change the rules for depreciation on occasion, so it is wise to work with a qualified tax accountant when calculating depreciation to avoid inadvertently breaking the rules and negating the value of this important investment tool. Once investors have determined that their property is eligible for depreciation, they will need to understand how to calculate depreciation deductions.
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.
As informed investors we should understand the risks associated with real estate investing and that there is no guarantee. Please do your due diligence.
