Depreciation: The #1 Tax Break For Doctors

depreciation

Depreciation: The #1 Tax Break For Doctors

Most doctors fall into the 32% or 37% tax bracket. Needless to say, taxes are and will continue to be our BIGGEST expense.

After purchasing a building and new equipment many years ago, I remember my CPA mentioning something about saving taxes with depreciation.

At first it seemed like an ugly word as it sounds like the opposite of appreciation.

But then he went into this long winded explanation about cost segregation studies and “useful life” of assets and I didn’t have a clue what he was talking about.

But playing the cool “smart” doctor, I couldn’t let him know my ignorance on the subject so I just nodded my head as if I understood and hoped what he was telling me was true.

One of the many mistakes I’ve made is not understanding how the tax law works.

Honestly, if you don’t learn the basics, then get ready to pay Uncle Sam a big chunk of your income the rest of your career.

But hey, who wants to do that right?

I don’t and you shouldn’t either.

That’s why you’re here with me and hopefully when you finish this article, you’ll understand:

  • What is deprecation?
  • Why depreciation is important
  • How depreciation is calculated

Ready to get started?

What Is Depreciation?

depreciation

Depreciation is one of the most powerful wealth building tools the IRS gives to tax payers.

Yes, they actually do have a heart like the Grinch!

It’s a tax break available to any business owner who buys property (not only real estate), which allows you to write off the value of an asset over time.

Instead of real estate, let’s use the computer I’m currently typing on.

Once you buy a laptop and put it into service, it immediately starts to go down in value (like a car).

Over a period of 1,3 or 5 years, it really starts to lose its value.

Let’s now get into my favorite investment, real estate.

What Are Some Depreciation Examples?

Straight line depreciation

depreciation

Although commercial real estate typically appreciates over time, the IRS allows you to depreciate its value called a paper or phantom loss.

An example is that they allow owners of resident occupied real estate to depreciate their property over 27.5 years.

An example would be of an apartment complex that you purchased for $3.5 million with a net operating income (NOI) of $200,000.

In this situation, the land, which is not depreciable, was valued at $750,000.

That leaves the remaining $2.75 million to be depreciated which looks like this:

$2.75 million/ 27.5 years = $100,000

Results

In this scenario (we’re assuming you’re in a 37% tax bracket), the IRS allows you to depreciate $100,000 a year over the next 27.5 years as a paper loss. ($2,750,000/27.5 yrs = $100,000)

Remember, the NOI was $200,000 but we’re NOT going to have to pay taxes on that amount.

Why?

You’re allowed to subtract out that depreciation expense.

($200,000 – $100,000 = $100,000)

This means that you’re only going to be taxed on the $100,000.

Tax without depreciation

  • $200K x 37% = $74,000

Tax with depreciation

  • $100K x 37% = $37,000

As you can see with depreciation, the amount of taxes you pay are cut in half!

The depreciation represents a paper loss that can be taken against the actual gain from cash flow of the property which gets reported on a K-1.

If you have K-1 passive gains from other business activity then you can use those to offset actual gains which saves taxes in other areas of your portfolio.

Accelerated depreciation

Why wait 27.5 years to benefit when the IRS allows you to front load or accelerate the depreciation.

This can be accomplished via a cost segregation study which allows items to be depreciated over shorter time schedules of 5, 7, and 15 years.

This creates larger paper losses in the early years of ownership.

Instead of taking the property and dividing into 2 components (building and land), you now divide it into 4 components:

  1. Land
  2. Building
  3. Personal Property
  4. Land Improvements

Personal property is the non-permanently affixed items to the building such as:

  • carpet
  • cabinets
  • drapes

It gets depreciated either over 5 or 7 years.

Land improvements are any improvements to the land such as:

  • parking lots
  • curbs
  • swimming pool
  • sidewalks

It gets depreciated over 15 years.

Let’s continue using the example above:

  • $3.5 million property
  • $750,000 land

We’re now left with the $2,750,000 apartment building which we can break up (segregate) into:

  • personal property ($300,000)
  • land improvements ($250,000)

$2,750,000 – $300,000 – $250,000 = $2,200,000 which is what the building is NOW worth

  • $2,200,000 building/27.5 = $80,000

Remember, we’re allowed to depreciate $80,000/year for the next 27.5 years.

  • $300,000 personal property/5 = $60,000

We can depreciate $60,000 each year over the next 5 years due to the personal property.

  • $250,000 land improvement/15 = $16,670

We can depreciate $16,670/yr over the next 15 years due to the land improvement.

Total depreciation: $156,670 = ($80,000 + $60,000 + $16,670)

  • $200,000 – $156,670 = $43,330

We’re now only taxed on the $43,330!

Results

Tax without depreciation

  • $200K x 37% = $74,000

Tax with depreciation

  • $100K x 37% = $37,000

Tax with accelerated depreciation

  • $43,330 x 37% = $16,032

With using the accelerated depreciation, our tax bill lowers even more to $16,032.

I hope you’re starting to see how great adding real estate, even passive real estate, to your portfolio can be to grow your wealth.

Bonus depreciation

Bonus depreciation is a form of accelerated depreciation that allows you to take the benefit in the FIRST year instead of over the 5,7 or 15 year schedule.

The Tax Cuts and Jobs Act in 2017 was passed that stated if property was or is purchased after September 27, 2017, and before January 1, 2023 then you can get a first year 100% benefit.

Unfortunately, this benefit is going to get phased out by 20% each year through 2026.

Let’s revisit our example:

  • $3.5 million property
  • $750,000 land
  • $2,200,000 building / 27.5 = $80,000
  • $300,000 personal property / 5 = $300,000
  • $250,000 land improvement / 15 = $250,000

Instead of taking the personal property and dividing it by 5 and taking the land improvement and dividing it by 15, we can take the entire benefit in year one.

$80,000 + $300,000 + $250,000 = $630,000 in paper loss which cancels out the $200,000 in gains.

As a matter of fact, not only does it erase it, it leaves you with $430,000 of depreciation that first year.

Total depreciation: $630,000

$200,000 – $630,000 = -$430,000

Results

Now with the bonus depreciation, it’s entirely wiped out the $200,000 so you’re tax on $0 is zero!

Tax without depreciation

  • $200K x 37% = $74,000

Tax with depreciation

  • $100K x 37% = $37,000

Tax with accelerated depreciation

  • $43,330 x 37% = $16,032

Tax with Bonus Depreciation

  • $0 x 37% = $0

Now do I have your attention?

Why Is Depreciation Important?

Depreciation is important because you now have a legal way to lower your taxes!

According to the IRS, there are millions of Americans that receive a significant amount of passive income which is reported on their K-1 tax form.

These individuals would be able to take a massive windfall of depreciation utilizing a bonus depreciation.

Let’s say that Dr. E reports $100,000 of K-1 passive activity gain from an unrelated business and $70,000 of first-year bonus depreciation from a rental property.

Instead of paying tax on $100,000, he can subtract the $70,000 of depreciation and only be taxed on $30,000 of income in that year.

Bottom Line

Hopefully this article has peaked your interest about how powerful adding real estate into a high income earners’ portfolio is with regards to tax benefits.

I didn’t even get into the multiple streams of passive income that you’d put in your pocket which is another HUGE reason to invest.

As a side note, if you don’t have a CPA that’s familiar with real estate investing, consider consulting with one before investing.

Ready To Start Reaping the Benefits of Depreciation?

Once you join our exclusive members-only Passive Investors Circle, you’ll have direct access to all of the syndicators I trust and personally work/invest with in order to lower taxes, make passive income and get out of the rat race.

Click HERE to join the Free Passive Investors Circle today.

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10 comments

  • I absolutely love depreciation and because the losses are so large early on you get to bank what you don’t use and carry it over to later years.

    The best part about it is that if you do a 1031 exchange (or keep property til death and heirs get a step up basis) you can actually never have to pay it back (otherwise you will get a tax hit that recoups the depreciation you claimed earlier)

  • I love depreciation. For several years, all of my passive income was tax free. Today, I get about half of my passive income tax free and pay on the rest. That means my passive income taxes are cut in half. That is a 50% decrease in taxes, 19 years after my first apartment was purchased. I’m adding this to Fawcett’s Favorites this week.

    Dr. Cory S. Fawcett
    Financial Success MD

  • Matt Bailey

    Can you use depreciation against other 1099 or do you have to have meet real estate professional criteria?

    • Without knowing your situation, it’s hard to answer. Assuming you do not file REP status, then your passive losses would ONLY offset your passive gains and NOT active 1099 income. If you have further questions, check with your CPA.

  • If you take the bonus depreciation and then say after 2 year or so you sell the property, how does it effect your taxes?

  • DJS

    I think you really need to be careful about the Real Estate Professional (REP) issue. Most physician will not be able to quality for that, if audited. Of course, there are multiple avenues to address this (spouse, for example).

    It is important to review with your tax specialist if you are deducting all real estate losses (A lot of which will be depreciation) against your earned income.

  • VS reddy

    As great as depreciation is and that is lowers one’s taxable income, it is remiss to not mention “depreciation recapture” at the time of the sale of the property. As we all know, the amount of depreciation taken during the life of ownership of the real asset is then used to REDUCE the cost basis. Then, at the time of sale, the sale price minus the revised cost basis will be what is taxed at the CAPITAL GAINS rate (23.6%) rather than at the income tax rate.

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