Depreciation is an income tax deduction that the IRS allows investors to take to recover the cost of the property. It is one of the tax advantages of owning investment real estate, although depreciation also applies to other business assets, like machinery. The depreciation process provides recompense for the investment cost during the asset’s gradual loss of utility. Whether you own an office building, a retail property, or a residential rental, you can use the depreciation process to recover some of the investment over time.
It's important to note that depreciation applies to property improvements, not the land underneath the structure. According to the IRS, land does not lose value and thus is not subject to depreciation. To depreciate your asset, you must first differentiate between the land value and the depreciable value of the improvements.
How do I calculate depreciation?
As noted, the land value is not included in the calculation. So, use the purchase price for the property minus the land value. Real estate is usually depreciated using the MACRS (Modified Accelerated Cost Recovery System), which assigns a depreciation period to each type of asset. For example, commercial real estate depreciates over a 39-year period. However, residential rentals have a depreciation period of 27.5 years. The tax assessment, in either case, will typically differentiate between the value of the land and improvements.
You can deduct the depreciation amount from your income each year. However, when you dispose of the property, you may have to pay back some of the depreciation deductions in a procedure referred to as depreciation recapture.
Why do I have to pay depreciation recapture?
Depreciation recapture is how the IRS reconciles the property value with the depreciation deductions you have taken. It's worth noting that even if you don't take the deduction, the IRS will recapture the amount you could have taken.
For example, if you buy rental property with a value of $200,000 (not including the land), you can deduct a depreciation allowance of 3.6 percent annually, or in this case, $7,272. You then use that deduction to reduce your taxable net income. However, the IRS subtracts that deduction from your cost basis. Suppose you take the deduction for five years, deducting a total of $36,360. When you sell the asset, you reduce the cost basis by that amount to determine your capital gain. Moreover, the portion of the gain attributable to depreciation is subject to taxation at your ordinary income rate, not the lower capital gains tax rate.
Is there any way to avoid paying depreciation recapture?
Investors can defer both the realization of capital gains taxes and the depreciation recapture by using a 1031 exchange to sell the property and reinvest. For example, if you intend to sell your rental or business property, using a 1031 exchange allows you to defer paying these because you are reinvesting the entire proceeds from the sale into a new asset. Because this can be a substantial advantage, the IRS has created strict rules governing the execution of the 1031 exchange. Remember that this process does not eliminate your need to pay taxes and recapture, but it defers it. In addition, taxpayers can execute sequential 1031 exchanges to continue the deferral. If they continue this until distributing the asset to an heir, the heir benefits from the step-up in basis and will not owe either taxes on the capital gain or depreciation recapture.
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.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
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.
Hypothetical examples shown are for illustrative purposes only.
