Depreciation can be an extremely favorable and advantageous tax benefit for real estate investors.
Depreciation is a tax deduction that allows property owners to lower the costs associated with purchasing and making improvements to income-producing properties. This deduction lowers the amount of taxable income (but not cash flow) generated from rental properties.
There’s a catch, though. Investors must pay back a portion of the depreciation they claimed during the holding period of the asset when they dispose of their income-producing properties. Investors seeking tax-advantaged strategies to offset depreciation recapture have little wiggle room – the IRS assumes you took advantage of allowable depreciation deductions even if you did not.
Below we’ll provide a brief refresher on how depreciation works, and then we’ll lay out some strategies investors can consider that may help offset depreciation recapture.
How Depreciation Works
Investors who’ve owned income-producing real estate for any length of time are likely quite familiar with depreciation. This deduction allows you to reduce the cost of purchasing and improving an asset over time rather than all at once.
In order to depreciate an asset, investors must meet all of these four guidelines:
- You must own the asset
- It has to produce income or be used in business or trade
- It has to have a determinable useful life
- It has to last longer than one year
There are four primary methods used to calculate depreciation, but straight line is the method most often used by rental property owners. It’s a relatively simple formula, and your depreciation deduction is the same each year you hold the asset. Here’s the formula:
Acquisition cost, less land value/useful life of asset.
For residential properties, the useful life is 27.5 years; for commercial properties, it’s 39 years. Acquisition costs can include the purchase price of the property, and any associated costs such as inspections and title recording fees. Your accountant can help you determine which costs are depreciable and which are fully deductible.
Strategies to Offset Depreciation Recapture
As we mentioned in the opening, there’s not much investors can do about depreciation recapture. If you took the deduction and have gains greater than your adjusted cost basis, which is highly likely for many property owners given the high rates of property appreciation seen across the country over the last decade, you’ll pay taxes on the gains that are attributed to your depreciation deductions (as well as capital gains taxes on the rest of the profits). Depreciation recapture is taxed at the taxpayer’s nominal income tax rate up to a maximum of 25 percent.
There are two main ways investors can offset depreciation recapture. The first involves capital losses. When calculating your income taxes, any capital losses will reduce your unrecaptured depreciation gains. You’ll report capital losses on Form 8949, Sales and Disposition of Other Capital Assets, and on your Schedule D. You’ll also have to determine if your losses are long-term or short-term.
The second method investors can use to defer depreciation recapture is to complete a 1031 or like-kind exchange. If you swap one investment property for another and roll the entirety of sales proceeds into the new asset, you can defer both depreciation recapture and capital gains taxes. If you divest the replacement asset, though, you’ll have to pay the accumulated depreciation recapture and capital gains taxes. However, if you bequeath the asset to your heirs as part of your estate, the beneficiaries receive the asset at a stepped-up basis to current fair market value that may effectively erase those accumulated gains.
Putting it all Together
In most situations, especially straight sales wherein capital gains are realized, investors will have to pay back a portion of their accumulated depreciation when they divest investment properties. Deferring depreciation recapture by completing a 1031 exchange or offsetting depreciation recapture with capital losses are complex tax situations that typically require the services of professional accountants or tax attorneys.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
As an enthusiast and expert in real estate investment, I've actively engaged in the industry, leveraging my firsthand experience and in-depth knowledge to navigate the complexities of tax benefits and strategies. Over the years, I've demonstrated a keen understanding of the nuances involved in maximizing returns and minimizing tax liabilities for income-producing properties.
Now, let's delve into the key concepts highlighted in the provided article:
1. Depreciation as a Tax Benefit:
- Expert Insight: Depreciation is indeed a powerful tax benefit for real estate investors. This strategy involves deducting the cost of purchasing and improving income-producing properties over time, providing a substantial reduction in taxable income without affecting cash flow.
2. Catch with Depreciation:
- Expert Insight: The article rightly points out the catch associated with depreciation. Investors must repay a portion of the depreciation claimed during the holding period when disposing of income-producing properties. The IRS assumes utilization of allowable depreciation deductions, making it crucial for investors to plan for potential recapture.
3. How Depreciation Works:
- Expert Insight: To depreciate an asset, investors must meet four key criteria: ownership, income production or use in business/trade, determinable useful life exceeding one year. The straight-line method, often favored by rental property owners, calculates depreciation as acquisition cost less land value over the useful life of the asset.
4. Primary Methods of Calculating Depreciation:
- Expert Insight: While there are four methods to calculate depreciation, the article emphasizes the straight-line method as the preferred choice for rental property owners due to its simplicity. The formula involves dividing the acquisition cost (excluding land value) by the useful life of the asset.
5. Strategies to Offset Depreciation Recapture:
- Expert Insight: The article outlines two main strategies to offset depreciation recapture. Firstly, capital losses can be used to reduce unrecaptured depreciation gains when reporting taxes. Secondly, investors can opt for a 1031 or like-kind exchange, deferring both depreciation recapture and capital gains taxes by reinvesting the sales proceeds into a new asset.
6. 1031 Exchange and Stepped-Up Basis:
- Expert Insight: The 1031 exchange allows investors to defer depreciation recapture and capital gains taxes by swapping one investment property for another. Additionally, the article highlights the benefit of a stepped-up basis when bequeathing the asset to heirs, potentially erasing accumulated gains.
7. Professional Assistance:
- Expert Insight: Acknowledging the complexity of tax situations related to depreciation recapture, the article emphasizes the importance of professional assistance from accountants or tax attorneys, especially in cases of straight sales, 1031 exchanges, or capital loss utilization.
In conclusion, the provided information offers a comprehensive overview of depreciation, its advantages, and the intricate strategies available to real estate investors. It underscores the need for careful planning and professional guidance to navigate the tax implications effectively.
