Depreciation is one of the most powerful methods a property owner can use to lower their overall annual tax liability. In the world of Generally Accepted Accounting Principles (GAAP), there are many depreciation methods used today including Straight-Line, Declining Balance, Sum of the Years, Units of Production, etc. For the purpose of this article, we are going to focus on the two most common used for real estate; Straight-line & Declining Balance (Accelerated).
Today, we will touch on other important aspects surrounding the topic of depreciation including:
· What is Depreciation?
· Methods of Depreciation
· How to Calculate Depreciation?
· What is Depreciation Recapture Tax?
· How to Avoid Paying Depreciation Recapture Tax?
What is Depreciation?
Conceptually, depreciation is the reduction in the value of an asset over time due to natural elements. In real estate, depreciation is an income tax deduction allowance for the wear and tear, deterioration, or obsolescence of a property which helps investors recover the cost or other basis during ownership. This deduction can have a tremendous impact on an owner’s bottom line further increasing net cash flows.
Most commercial real estate properties have a valuable lifespan of 39 years while residential properties are 27.5 years. Depreciation factors the cost basis of the depreciable portion of the property (excluding land value) by its valuable lifespan to determine the annual deductible amount.
For example, let’s say you purchase a commercial building for $1,000,000. The land portion is appraised at $500,000 and the building is appraised at $500,000. Over the course of ownership, the IRS will allow a landlord to depreciate the value of the building ($500,000) over its useful lifespan of 39-years. In this case, if using the straight-line method, the landlord can offset $12,821 per year ($500,000 / 39 years) in depreciation from the net income. If a property generates $50,000 of annual pre-tax net cash flow but is depreciated by $12,821, the depreciation deduction allowance ($12,821) amount will reduce the total tax liability for a total adjusted taxable amount of $37,713.
Methods of Depreciation
There are many methods of distributing depreciation amount over its useful life. The total amount of depreciation for any asset will be identical in the end no matter which method of depreciation is chosen; only the timing of depreciation will be altered. Keep in mind that accelerated depreciation methods (such as declining balance or sum of the years' digits) can artificially reduce profit in the near term, followed by higher profits in later terms, which can influence reported cash flows. The following are some of the widely used methods.
Method 1: Straight-Line Depreciation Method
Straight-line depreciation is the most widely used and simplest method. It is a method of distributing the cost evenly across the useful life of the asset. The following is the formula:
Depreciation per year =
| Asset Cost - Salvage Value
Method 2: Declining Balance Depreciation Method (Accelerated Depreciation)
For specific assets, the newer they are, the faster they depreciate. As these assets age, their depreciation rates slow over time. In these situations, the declining balance method tends to be more accurate than the straight-line method at reflecting book value each year.
Declining balance is the most widely used depreciation method, which has a depreciation rate that is twice the value of straight-line depreciation for the first year. Use a depreciation factor of two when doing calculations for double declining balance depreciation. Regarding this method, salvage values are not included in the calculation for annual depreciation. However, depreciation stops once book values drop to salvage values. The following is the formula:
Depreciation per year = Book value × Depreciation rate
How to Calculate Depreciation?
Calculating depreciation is quite simple.
First figure out your Adjusted Basis. Your adjusted basis or cost basis is the original purchase price of the property plus any improvements and less depreciation taken during the life of the investment.
Net Adjusted Basis = Original Purchase Price + Improvements - Depreciation
Cost of Sale
Second, you will want to figure out the total Cost of Sale. There are several costs associated with selling a property. These costs include sales commissions, attorney, survey, title, inspections, deed & transfer taxes, etc. Any costs affiliated with the sale of property can be deducted from the total tax liability.
Total Cost of Sale = Sale Expenses + Misc. Expenses
Third, calculate the total equity within the property. Equity is the cash value (excluding debt) on a property. To determine one’s equity, take the gross selling price and subtract the closing costs, then further subtract the amount of any remaining debt. The remaining amount is equity.
Equity = Selling Price - Cost of Sale - Debt
What is Depreciation Recapture Tax?
So now we know, over the course of a building’s useful lifespan, the Internal Revenue Service allows a landlord to reduce the total pre-taxable income amount by certain annual depreciation allowance. But what happens to all that past depreciation write-off when an owner sells a property for profit? Depreciation Recapture Tax.
Depreciation Recapture Tax is a 25% IRS tax implemented to “recapture” the total deprecated amount taken against the income. Simply put, if you own a building for 10 years and have taken yearly depreciation against the income of $10,000 per year (10 years x $10,000 per year = $100,000), upon the sale of the asset your total depreciation recapture tax would be $25,000 ($100,000 x 25%).
Depreciation Recapture Taxable Amount = Total Depreciation Amount Taken x 25%
How to Avoid Paying Depreciation Recapture Tax?
Unfortunately, there is no possible way to AVOID depreciation recapture tax but, you can DEFER it. One-way real estate owners defer paying depreciation recapture taxes is through the IRC section 1031 or 1031 Exchange. We discuss these topics in detail in What is a 1031 Exchange, How Does a 1031 Exchange Work and Is a 1031 Exchange Right for You? A 1031 exchange will allow an investor to defer all capital gain and depreciation recapture taxes associated with the sale of a profitable real estate property. Utilizing a 1031 exchange is one of the best methods successful real estate investors grow their portfolios and preserve their total wealth.
In summary, depreciation is a vital component of any real estate owner’s investment strategy. It is affiliated with one of the many benefits that come with owning real estate. Depreciation allows a landlord to successfully reduce the total pre-taxable net income while improving their overall cash flow. This is vital when purchasing a property for income purposes.
In additional to lowering your total taxable income through depreciation on the front end, savvy investors can utilize a 1031 exchange to defer deprecation recapture taxes upon the sale as well. Our clients at Marzo Capital Group implement these strategies along with diversifying their portfolio through a Delaware Statutory Trust (DST). A Delaware Statutory Trust or DST is an investment vehicle that allows a 1031 exchanger to easily exchange directly into an institutional grade property while experiencing all the benefits of income producing real estate.
If you are ready to start a 1031 exchange, or have any additional questions about how it might work for your specific situation, schedule a consultation with one of our experts at Marzo Capital Group.
To learn more about real estate investing and how a 1031 can complement your portfolio, visit the Marzo Capital Group Learning Center.
Marzo Capital Group is not a licensed accountant or tax advisor. Please consult with your CPA before making any investment decisions.
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