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The Power of Depreciation

Real estate is filled with incredible ways to make money while reducing your tax liability. One of those powerful methods of reducing tax liability (i.e. paying less in taxes) is through depreciating the property over its useful life. Below we will cover straight line, accelerated, and bonus deprecation in detail, showing you how important these concepts are.

Straight Line Depreciation: An asset such as an apartment (residential use) or retail building (commercial use) are both classified as a physical structure. Most times apartments and retail buildings are used for business purposes or as investment vehicles. This is important because the property must be used for one of those reasons for it to be depreciated. The tax code states that any portion of the building that is used for personal use cannot be depreciated. For example, let’s say that the investor is living in one of the units in their investment property. This would mean that portion of the property that the investor lives in would not be eligible for depreciation. One more piece of criteria is that we can only depreciate the building structure; we cannot do so to the land that it sits on. We will find out later that although we cannot depreciate the land, we can do so to land improvements, like a fence or light posts. This topic will be addressed later in this blog. Now that we know what can be depreciated (physical structures used for business or investment purposes, excluding portions of the structure for personal use and the land the property sits on), let’s discuss how long they can be depreciated for. The tax code has defined structures that are for residential use have a useful life of 27.5 years, while structures for commercial use have a useful life of 39 years. Those life spans tell us how long it takes to depreciate the entire asset. Below, I have built out a depreciation schedule. You will notice that we have bought the property for $1 million but the land was assessed at $250,000. Therefore, the value of the asset that we can depreciate is the difference between the purchase price and land value which ends up being $750,000. We call that value the depreciable basis. We then take that $750,000 and divide it by either 27.5 or 39 based on whether it is residential or commercial. That gives us the annual depreciable allowance. In the table below, you will see under the Residential and Commercial column headers the annual depreciation allowance. After the end of each year, the depreciable basis is reduced by that annual depreciation allowance. This will continue until the 27.5 or 39 years is reached. At that point, the entire asset will have been depreciated to $0. The power of depreciation is the fact that it is tax deductible. We can take our annual taxable income ($75,000) minus the annual depreciation allowance (Residential, $27,273) which would leave us with a new, lower taxable income figure ($47,727). You can see how much we can reduce our tax exposure without having to do anything. The government and tax code favors property owners and allows us to use depreciation as a deductible expense. This is sometimes referred to as a phantom expense since we do not have to pay any cash out of pocket. This is one of the many reasons why owning real estate is so powerful. Accelerated / Bonus Depreciation: Just when you thought it couldn’t get any better, it does! Accelerated and bonus depreciation allow investors to expedite the standard depreciation schedule that we covered above (27.5 Years for Residential and 39 Years for Commercial). First, we can cover accelerated depreciation. When you buy a property, you are buying all the contents of it such as the land and internal contents of the building. What this type of depreciation allows us to do is depreciate land improvements and building contents. Examples of land improvements would be fencing, lighting, parking stalls, etc. Examples of building contents would be light fixtures, appliances, wiring, piping, etc. To determine how fast we can depreciate these items, we have a professional come perform a cost-segregation study. They may determine that the wires have a useful life of 5 years, appliances have a life of 7 years, concrete of 22 years, and 15 years for the fence. This now allows us to follow the same depreciation structure as above but over a much shorter period for those specific items. This would lower our annual taxable income even more! Next, we have bonus depreciation. This allows investors to depreciate up to 100% of qualifying real property expenditures in just the first year of ownership if those expenditures have a useful life of 20 years or less. Examples of these items are anything that have been determined through the cost-segregation study to have at most a 20-year useful life. In the example above, we had wires, appliances, and fencing that had useful lives under 20 years which means that we can depreciate their entire value within the first year! Through this tool, we continue to lower our annual taxable income and pocket more money!

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