Whether you’re a seasoned apartment investor or just starting out, you really need to know about rental property depreciation.
Clearly, the tax advantages inherent in real estate are substantial. And the cornerstone of those benefits is depreciation. The three types of depreciation you should know about are straight-line depreciation, accelerated depreciation, and bonus depreciation.
But before we take a deeper dive, let’s just start by defining depreciation.
In accounting terms, depreciation is the reduction in value of an item over time. For example, a high-end computer purchased today will not have the same value five years from now. It has depreciated in value.
Depreciation is a powerful tax-deferral strategy. It’s why our average investor doesn’t pay current year taxes on quarterly distributions for several years.
The “Useful Life” of Apartment Buildings
Different assets have variable life spans, so the IRS estimates the “useful life” of a whole host of assets. Historically speaking, they chose 27.5 years as the useful life for resident occupied real estate (including apartments).
Clearly, that useful life estimate doesn’t comport with reality.
If it did, then the oldest apartments in America would have all been built in the 1990’s. And we all know that isn’t true. After all, the national supply of apartments is flush with 1980’s, 1970’s, 1960’s built (and older) apartments.
Typically apartments don’t go down in value like computers. Instead, they have a long history of appreciating in value over time. And yet, the IRS allows investors to depreciate their properties.
Having the ability to depreciate an appreciating asset is a real financial gift. It creates a phantom or paper loss that can be used to offset actual gains. In other words, it defers taxes.
Let’s look at an example of how it works.
Straight Line Depreciation
In this example, let’s say 100 investors contributed equally to purchase a $35 million apartment building. For reporting purposes, that property has two components – the land and the “improvement.”
The improvement consists of all enhancements to the plot of land (structures, parking lot, swimming pools, etc.). The IRS allows rental property depreciation of the improvement, but not the land.
In this hypothetical example, let’s say that the land value is $7.5 million. When you subtract the land value from the purchase price, you arrive at an improvement value of $27.5 million.
$35 million (purchase price) – $7.5 million (land value) = $27.5 million
That $27.5 million improvement gets depreciated over a useful life estimate of 27.5 years. Utilizing straight-line depreciation (equal annual amounts of depreciation over the assets useful life), yields $1 million in paper losses each and every year for the next 27.5 years.
$27.5 million (improvement value) / 27.5 years = $1 million (annual depreciation)
Equally dividing that depreciation benefit among those 100 investors would give each $10,000 of paper loss to take against any actual gains from distributions.
Rental property depreciation is a powerful tax-deferral strategy. It’s why our average investor doesn’t pay current year taxes on quarterly distributions for several years.
As nice as straight-line depreciation is, we’re big fans of utilizing accelerated depreciation. As long-term holders of real estate, we like to frontload the depreciation benefit.
Accelerated depreciation requires a cost segregation study to identify and value all of the non-structural elements and land improvements.
Those items can be depreciated over shorter time schedules of 5, 7, and 15 years. Doing that creates larger paper losses in the early years of ownership.
By creating paper losses from depreciation, we can offset current yield from the property for years. It’s even possible to use any excess against other sources of K-1 passive activity gains.
If you still have excess depreciation benefit after offsetting your passive activity gains, you don’t lose that benefit. It simply gets banked and carried forward until there’s a year you can use it.
Using Depreciation To Offset Other Passive Activity Gains
To better understand, let’s look at an example. Consider two investors each placing $100,000 into a property. For this example, let’s only look at yield and not consider the other financial benefits of appreciation and principal pay down.
Let’s say their annual yield is 6% or $6,000 and each receives $10,000 in depreciation. Investor 1 has no other sources of passive income, but investor 2 has $4,000 of passive activity gains from another source.
$6K yield – $10K depreciation = $0 tax on yield in current year and -$4K in depreciation benefit banked for a future year.
$6K yield + $4K in other passive gains = $10K in total passive activity gains.
Subtract out $10K in depreciation = $0 tax on yield and $0 tax on other passive activity gains in the current year.
I think you would agree that tax deferred passive income is fantastic.
Bonus depreciation is something that typically isn’t discussed in multifamily apartment investing. That’s because it’s been a benefit reserved for newly built properties.
Bonus depreciation is also known as additional first year depreciation deduction. And as the name implies, this benefit allows one to immediately deduct a large percentage of an asset’s depreciation in year one.
Remember the cost segregation study used for accelerated depreciation?
It identifies “personal property” that can be deducted over five and seven years. It also identifies land improvements that can be deducted over 15 years. Historically speaking, bonus depreciation allowed owners of new properties to take 50% of those in year one.
37th Parallel doesn’t invest in new properties, so why is this important?
The reason is that the new real estate tax laws made two changes to bonus depreciation that are material. First, it expanded bonus depreciation beyond new properties. Used properties are now eligible for the same benefit. It also increased that benefit from 50% to 100% through 2022.
So we can throw away the accelerated depreciation schedules for now and get all of that frontloaded depreciation benefit in year one. This is particularly helpful for those that have significant K-1 passive activity gains from other sources.
In fact, we’ve heard from several investors planning on buying more apartments over the next few years. They want to take advantage of this significant tax deferral strategy.
Not only will they offset the yield from the property, but plan on using the excess rental property depreciation to offset other K-1 passive activity gains they have.
How Do You Depreciate Rental Property Improvements?
Another important factor to take into consideration is that not only can you claim depreciation on the cost of your rental property, but you can also claim depreciation on any improvements that are made to it as well.
There are many different expenses that qualify as improvements, but some of the most common include new additions to the property (such as a new room or garage), new carpeting, accessibility upgrades, or roof replacements. Plus, improvements are treated as separate property by the IRS.
Be sure to keep accurate records of all improvements that are made to your rental property, including costs of materials and labor, because these will be needed when claiming rental property depreciation.
Using a Rental Property Depreciation Calculator
So now that you understand that rental property depreciation is a phenomenal tax benefit to those who take advantage of it, you may be wondering how exactly the depreciation is calculated.
Which depreciation method you use, whether it’s straight line, accelerated, or bonus, will determine exactly how you calculate this number.
Most depreciation calculators use straight line depreciation as their method because it’s the easiest to calculate. The others are a little more complicated so it’s recommended that you speak to your tax professional to determine which method would be best for you along with what the depreciation amounts would look like.
How to Leverage This Unique Tax Benefit
In the end, there are many reasons to hold commercial multifamily real estate in your portfolio. The tax advantages are tremendous and have recently gotten better. Understanding how rental property depreciation works can be helpful in deciding what allocation in this asset class is best for you.
If you have significant passive income that is leading to taxable gains, now might be one of the best times in history to consider investing in commercial real estate with us. The 100% bonus depreciation can create large sums of paper losses to offset those gains resulting in lower tax bills.
Be sure to consult with your trusted tax advisor to know whether or not that strategy would work for you and as always, don’t hesitate to let us know if we can help.
We have a live webinar coming up that focuses on the tax benefits of real estate investing. To learn more, visit our webinars page.