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If you are in the field of real estate, depreciation might be a tool you can utilize to reduce your taxes- and who doesn’t love a good tax write off? As investors, we want to use every available resource to increase our take home income and returns on investments. Although land is never depreciable, property is. If you own a property that is producing income, expected to last for more than a year, and has a determinable useful life- then you have met the requirements for depreciation. Depreciation not only applies to property and buildings, but can also apply to machinery, vehicles, and equipment. Understanding how to use depreciation for your benefit is crucial to recovering as much money as possible in investments.
Depreciation is legally acknowledging the decrease of an asset’s value over time due to the accumulation of wear and tear throughout the years. It spreads out a property’s deduction cost throughout the years of its useful life rather than all at once. Although property value may increase and may not decrease in actuality, depreciation is the acknowledgement of loss on paper. Through depreciation, one is able to calculate an estimate of the decline of a property over a period of time and utilize it as an annual income tax deduction- meaning it is able to lower a property investor’s annual taxable income. Depreciation is significant because it allows costs of an asset to be recovered, and in some cases, an asset’s value can be written off completely. Understanding depreciation is crucial to legally reducing your taxes and keeping as much of your hard earned money as possible.
Types of Depreciation
Two of the main types of depreciation are straight line depreciation and accelerated depreciation.
In straight line depreciation, a single home or multifamily property depreciates the same amount of value over a 27.5 year period and a commercial property depreciates over a 39 year period. However, in accelerated depreciation, assets depreciate at a much quicker rate, usually within 3-7 years. For example a counter could fully depreciate in 4 years, a dishwasher in 5 years, etc. In order for multifamily investors to generate massive savings, they pay for a cost segregation study to be done on the assets that depreciate at an accelerated rate. Cost segregation studies are one of the most effective ways to reduce income tax liability which speeds up the rate at which investors can actually claim their tax deductions. Since the accelerated depreciation assets usually have a lifespan of 5-7 years, that is the same time frame in which investors get their tax deductions which leads to greater, quicker cash flow. The IRS has stated that cost segregation is the preferred means of calculating depreciation because they believe it is the most accurate way. Cost segregation studies are usually done by engineering firms who are able to accurately calculate depreciable lives to components of your real estate assets. According to the IRS, “Cost segregation studies are prepared for a variety of reasons (e.g., income tax, financial accounting, insurance purposes, property tax), and many different methodologies and procedures are used. While neither the Internal Revenue Service nor any group or association of practitioners prescribes a specific methodology, there are certain approaches (e.g., studies based on actual costs or on proper estimation techniques) that produce more accurate and reliable allocations.” Read the full article here: https://www.irs.gov/pub/irs-pdf/p5653.pdf
As mentioned earlier, two of the three main types of depreciation are straight line depreciation and accelerated depreciation. The third is bonus depreciation, which goes hand and hand with accelerated depreciation.
Straight Line Depreciation
Straight line depreciation is the simplest method of depreciation because the asset depreciates the same amount of money every year of its useful life. This makes depreciation very easy to calculate and understand. Generally, a multifamily real estate property has an IRS depreciation period of 27.5 years. So to calculate straight line depreciation, you can use this formula below:
Straight Line Depreciation = (Cost of an Asset – Salvage Value) / Useful Life of an Asset
The Salvage Value is the residual value of an asset at the end of its useful life assumption, after accounting for the total depreciation. If you are depreciating an asset’s property value to $0, then it would just have the land value as the salvage value as the land does not depreciate.
Accelerated depreciation is the rapid increase of depreciation of an asset in the earlier years of its life, with a slower depreciation later on in its lifespan. Most of the depreciation happens earlier on, so the additional expense reduces the income and therefore the taxed amount in the early years. Accelerated depreciation allows for larger tax write offs in the earlier years of an assets life which can improve cash flow more quickly.
There are a few methods for accelerated depreciation such as the double digit declining method and sum of years’ digits (SYD). To calculate accelerated depreciation using SYD, combine the digits of the expected life of the asset. For example, if an asset has an expected life has a three-year life, the base of the sum-of-the-digits one through three, or 1+2+3=6. In the first depreciation year, 3/9 of the depreciable base would be depreciated. In the second year, only 2/6 of the depreciable base would be depreciated. This continues until the 3rd year where the remaining ⅙ is depreciated. Here is the formula used for this:
Sum of the Years’ Digits Depreciation = Depreciable Cost x (Remaining Useful Life / Sum of Years’ Digits)
Bonus and accelerated depreciation go hand in hand because bonus depreciation allows for accelerated depreciation. Through bonus depreciation, real estate professionals and investors are able to write off more of the cost of an asset, resulting in saving more money. The IRS in this way has partnered with investors to encourage purchases in the market through maximizing deductions. According to the US Bank, “Bonus Depreciation is an additional first-year depreciation allowance. According to the Internal Revenue Service (IRS), bonus depreciation allows business taxpayers to deduct additional depreciation for the cost of qualifying business property, beyond normal depreciation allowances. It’s intended to spur capital purchases by all business taxpayers, small, mid-sized and large… The rules allow Bonus Depreciation to 100% for all qualified purchases made between September 27, 2017 and January 1, 2023. Bonus Depreciation now ramps down to 80%, starting in 2023. Bonus depreciation will continue to ramp down for ensuing years: 60% for 2024, 40% for 2025, 20% for 2026, and 0% beginning in 2027.” To calculate bonus depreciation, use this formula here:
Bonus Depreciation Rate (currently 80% as of January 1, 2023) x Cost of an Asset
Although depreciation is a useful tool to save money during the process of owning a property, what happens when you decide to sell it? You are left to face depreciation recapture. According to the IRS, once an investor sells a property they have claimed depreciation on, the investor must pay taxes for the summed depreciated amount of the years it was held. It is repaying the IRS for the profit made by paying income tax on one’s gain. However, there is a legal way out of this through the 1031 Exchange. Want to know more? Read our article on 1031 Exchange.
Invest with us!
Depreciation allows real estate investors to avoid huge expenses, recover money, and get the best financial results possible. At Prime Investment, we take into consideration depreciation, market and economic conditions as they are crucial to determining costs and being aware of possible economic turndown to save and keep as much money as possible. We often reflect on Warren Buffet’s Number 1 rule of investing which is – never lose money.
Investing in multifamily real estate offers one of the best ways for you to build wealth. At Prime Investment, we value, highly uphold, and strive for financial freedom, fully passive income, and peace of mind. Our interests are highly aligned with our investor’s interests – when the investment is a huge success we all benefit together. Interested in becoming our next investor? Overcome entry-barriers and invest in real estate with our expertise. It is one investment with many benefits. Start your passive income today.
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