Real Estate Depreciation: #1 Tax Strategy for Busy Professionals

Real Estate Depreciation: #1 Tax Strategy for Busy Professionals

As a doctor or other high-income professional, you probably fall into the highest tax bracket (37%), which is a significant expense.

When I started my dental practice from scratch, I bought a new office along with equipment to furnish it. My CPA told me I could save money on taxes with an annual depreciation expense and a depreciation schedule.

At first, depreciation seemed confusing, but it’s important to understand the basics of tax law, including how a tax deduction can be used to decrease your active income.

If you don’t learn about depreciation and other tax strategies, you could end up paying a large portion of your income to the Internal Revenue Service (IRS) throughout your career. Unfortunately, this is what happens to most of us, which can start to lead to burnout early on in our careers.

Related article: I Can’t Do It Anymore: 3 Reasons Doctors Hate Their Job

It’s worth taking the time to learn about depreciation and other tax strategies to help reduce your income taxes and keep more of your hard-earned money. Don’t make the mistake of ignoring the importance of understanding tax law – it can pay off in the long run.

This article highlights:

  • What is real estate depreciation?
  • Why depreciation is important?
  • What are the 3 types of depreciation in real estate?
  • How is depreciation calculated in real estate?
  • How to find out the depreciation rate of property

Disclaimer: I’m a periodontist and NOT a tax advisor or financial advisor. Please contact one regarding your personal situation.

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What Is Real Estate Depreciation?

Real estate depreciation is a non-cash expense that lets investors get a tax benefit for the property’s wear and tear over time. This deduction is based on the idea that all physical assets, including real estate, lose value over time because of things like age, use, and becoming outdated.

When a property is depreciated, the owner can claim tax deductions for a percentage of its value each year on their tax return. This deduction is calculated depending on the useful life of the property and its cost.

Most of the time, there are two types of real estate depreciation:

  • depreciation of the building
  • depreciation of the land

The building is a “depreciable asset” because it will lose value over time.

The land, on the other hand, is not a “depreciable asset” because it will not lose value.

Here’s a basic example of how this works: If a property owner invests $500,000 in an apartment building expected to last 27.5 years, they can deduct $18,182 per year ($500,000 / 27.5 years).

This deduction is applied to the income generated by the property, lowering the taxable income and tax liability.

Real estate depreciation usually is offered exclusively for rental and commercial real estate, not for personal property. It’s crucial to remember that while a property owner can claim a depreciation deduction on their tax return, the property’s actual worth may not decline with time.

The deduction simply allows the owner to recover the cost of their investment over the useful life of the property.

Importance of Understanding Real Estate Depreciation

Understanding real estate depreciation is critical for several reasons:

#1. Tax benefits

As previously stated, real estate depreciation allows property owners to claim a tax deduction for a percentage of the property’s worth each year. This can help the owner’s taxable income and, as a result, their tax liability.

Related article: 10 Tax Strategies for High Income Earners: Avoid the Tax Man

#2. Improved cash flow

Rental property owners can improve cash flow by lowering their taxable income and raising their net income by claiming a depreciation deduction. This is especially useful for landlords, who can use the extra cash to pay down debt or make new investments.

#3. Better decision making

Understanding depreciation can help property owners make more educated investment decisions. For example, they may be more willing to invest in a commercial property with a longer usable life because this can lead to a higher commercial real estate depreciation deduction and more tax savings over time.

#4. Tax law compliance

To claim depreciation deductions, you must follow specific tax laws and rules. Property owners can guarantee compliance with tax requirements and avoid any potential complications with the IRS by comprehending these rules.

To calculate the annual depreciation deduction for a rental property, you must first estimate the property’s cost basis and then select the appropriate depreciation method.

Here’s how it’s done:

How Is Depreciation Calculated In Real Estate?

Step #1. Determine the building’s cost basis.

The asset’s calculated value at the time it was bought is the cost basis. This isn’t just the price of the property, but it’s the price after all the necessary changes have been made. After an asset is purchased, the cost basis may need to be changed.

For instance, if you spend $75,000 remodeling a house, that cost will be added to the cost basis.

Some other costs, like legal fees, transfer taxes, property survey fees, and other closing costs, can be added to the cost basis when the investor buys the property. You can also add to the cost basis any debt that the buyer takes on from the seller.

Step #2. Select the proper method of depreciation.

The General Depreciation System (GDS) and the Alternative Depreciation System (ADS) are the two basic techniques for computing depreciation for rental properties.

GDS applies straight-line depreciation to both residential and commercial rental properties, with a residential recovery period of 27.5 years and a commercial recovery period of 39 years.

You can divide the property’s value by the recovery period to calculate annual depreciation using GDS.

ADS is typically applied to properties that are used for a qualified business purpose:

  • for less than 50% of the year
  • have a tax-exempt use
  • are financed with tax-exempt bonds
  • or are principally used for agricultural or farming activities

ADS has a 30-year recovery period. 

What Are The 3 Types Of Depreciation In Real Estate?

#1. Straight line depreciation

Straight-line depreciation is a method of calculating the decrease in value of an asset over time. 

To calculate straight-line depreciation, you must first estimate the cost of the asset, its useful life, and residual value.

  • The asset’s cost is what you paid for it.
  • The asset’s useful life is the amount of time you think it will be used for your business.
  • The residual value is the estimated value of the asset at the end of its useful life.

Once you have these three values, you can determine the annual depreciation expense by subtracting the residual value from its cost and dividing the result by the useful life.

For example, a $200,000 single-family rental home with a useful life of 27.5 years and a residual value of $0 has an annual depreciation expense of $7,278.00 ($200,000/27.5 = $7,278.00).

#2. Accelerated depreciation

Accelerated depreciation is a way to figure out how much the value of an asset has dropped in a shorter amount of time than straight-line depreciation. This method enables the depreciation of specific building components, such as flooring, cabinets, appliances, and parking lots, to be spread out over shorter time periods of 5, 7, or 15 years.

Real estate investors who want to take advantage of accelerated depreciation may employ a group of engineers to conduct a cost segregation study. This entails isolating distinct components of a property, such as the structure, the land, and any improvements, and determining which components can be depreciated over shorter time periods.

A cost segregation study seeks to maximize the depreciation deductions that investors can claim in the short term, consequently lowering the company’s tax burden.

Need a cost seg group? Check out the one we use HERE.

#3. Bonus depreciation

Bonus depreciation is a tax break that allows businesses to deduct a larger amount of the cost of certain types of property in the year they are put into service. This is especially helpful for real estate investors as it lets them claim a bigger tax deduction and pay less in taxes the year they buy the property.

Tax laws in the United States usually require businesses to spread out the cost of tangible property over a number of years, depending on how long the property will be useful.

Bonus depreciation allows businesses to deduct a larger amount of the cost of property in the year it’s placed in operation rather than spreading the deduction over multiple years. This can save a lot of money on taxes, especially for businesses that buy new property or rehab old property.

Bonus depreciation is often given for certain kinds of property, like new property that hasn’t been used yet or property used for business. In the case of real estate, this could entail things like new building, extensive renovations, or the purchase of property for commercial use.

Want to learn more about using real estate to lower your taxes?

Check out this video:

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How Much Will Depreciation Affect My Taxes?

Taxpayers who own rental property can list depreciation as one of their expenses on Schedule E when they file their annual tax returns.

How much the investor’s tax bill will go down depends on what tax bracket they are in now. This percentage will be used to calculate the total amount that can be deducted.

They can benefit from depreciation since it allows them to claim deductions for the purchase price of a property spread out over several years while also allowing them to claim deductions for each of those years individually. It helps lessen the effects of losing money on investments more than it helps to make money.

Since the IRS occasionally changes the depreciation rules, it’s best to work with a knowledgeable tax accountant to figure out depreciation so you don’t accidentally break the rules and lose the benefits.

Rental Property Depreciation Example

Let’s take a look at an example of how depreciation can affect your taxes.

For instance, the annual depreciation expense on a residential property with a cost basis of $350,000 would be $12,045 ($350,000 divided by 27.5 years).

The tax savings due to the depreciation expense for someone in a 37% tax bracket would be $4,487 (37% of the annual depreciation expense of $12,045).

In other words, your tax bill would be lowered by $4,487 each year. 

Here’s a table to break it down for you:

Concept Explanation
Cost basis The original cost of a property is $350,000
Depreciation expense The amount by which the cost basis of a property decreases each year is $12,045
Depreciation period The number of years over which the cost basis of a property will be depreciated, which in this case is 27.5 years
Tax bracket The percentage of income that an individual is required to pay in taxes, which in this case is 37%
Tax savings The amount of money saved on taxes due to the depreciation expense, which in this case is $4,487
Concept Amount
Cost basis $350,000
Depreciation expense $12,045
Depreciation period 27.5 years
Tax bracket 37%
Tax savings $4,487
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What is depreciation in the context of real estate investment, and how does it benefit rental income?

Depreciation for real estate investment refers to the process of deducting the costs associated with purchasing and improving a rental property over its useful life, as defined by the IRS. This allows investors to reduce their taxable income, potentially lowering the amount of taxes owed on rental income. By using the Modified Accelerated Cost Recovery System (MACRS), residential rental properties are depreciated over 27.5 years, and commercial properties over 39 years, using the straight-line method. This tax break acknowledges the property’s wear and tear over time, excluding the value of the land which does not depreciate.

How is the depreciation amount for a rental property calculated for tax purposes?

The depreciation amount for a rental property is calculated by subtracting the value of the land from the total cost of the property (including both the purchase price and any capital improvements) to determine the depreciable basis, which is the value of the building alone. Using the straight-line method for depreciation purposes, this amount is then divided by the recovery period defined by the IRS (27.5 years for residential properties and 39 years for commercial properties) to find the annual depreciation amount. This calculated depreciation can be deducted from rental income each tax year to lower taxable income.

What is depreciation recapture, and how does it affect the sale of investment property?

Depreciation recapture is a tax provision that requires property owners to pay tax on the amount of depreciation claimed when they sell the property. Essentially, if the property is sold for more than its adjusted basis (the original cost minus total depreciation claimed during ownership plus any capital improvements), the IRS treats the excess depreciation as taxable income, taxed at the depreciation recapture rate, which may be different from the capital gains tax rate. This ensures that the tax benefits received during the property’s rental period are accounted for at the time of sale.

Can you deduct the entire cost of property improvements immediately for depreciation purposes?

No, you can’t deduct the entire cost of property improvements immediately for depreciation purposes. Instead, the cost of capital improvements—expenses that extend the life of the property, increase its value, or adapt it to a new use—must be capitalized and depreciated over their useful life according to IRS rules. This means that the cost of significant improvements will be spread out and deducted over several years, not all at once. For residential rental property, this would typically be over a 27.5-year period using the straight-line method.

What are the first steps to take when calculating depreciation for an investment property for the first tax year?

The first step in calculating depreciation for an investment property for the first tax year involves determining the property’s cost basis. This includes the purchase price of the property, any associated legal and closing costs, and the cost of any capital improvements made to the property prior to putting it into service. Next, separate the cost of the land from the cost of the building, as only the building portion is depreciable. Finally, apply the IRS-approved depreciation method, typically the straight-line method for both residential and commercial properties, to calculate the annual depreciation amount based on the property’s adjusted basis and useful life as defined by IRS Publication 527 for residential rental properties.