How Does Depreciation Help with Taxes?

As an investor, you probably already understand that taxes are a part of life. And, if you are an investor with a knowledgeable tax-planning expert on your side, you’ve probably figured out how to reduce or defer some of those taxes. One such way to do this is through depreciation.

Depreciation can be a valuable tool, especially for real estate investments. When used properly, it can reduce some of the tax burden connected with your investments. 

Defining Depreciation

The IRS’ basic definition of depreciation is “the recovery of the cost of the property over a number of years. You deduct a part of the cost every year until you fully recover its cost.” The IRS reasoning behind depreciation is that it’s difficult to deduct the cost of purchase, improvement, or service placement of a property in an entire year. The IRS also points out that “property” includes machinery, equipment, buildings, vehicles, and furniture.

But not all property is subject to depreciation. To fit into this situation, the property must:

• Be owned by you
• Be used in a business or income-producing activity
• Have a determinable useful life
• Be expected to last more than one year
• Not be expected property; this includes:
• Certain intangible property
• Certain term interests
• Equipment used to build capital improvements
• Property placed in service and disposed of in the same year

When it comes to real estate investments, depreciation represents a tax deduction that allows for the recovery of property or asset costs that are placed into service as a rental income source. 

Where Did it Come From?

This history of depreciation is tied to the history of financial accounting. Experts note that the earliest mention of depreciation took place in the early 16^th century. Before that time, economic activity was primarily agrarian, with few assets that were depreciable.

Depreciation became more common throughout the industrial revolution, during which business activities became more complex, and the use of large, mechanical equipment more frequent. This, in turn, resulted in a higher requirement for capital, leading to the need for depreciation accounting. 

Finally, publicly owned companies drove the need for, and use of, depreciation. Why? Owners who had interests in public companies wanted to understand how depreciation would impact income and/or loss of the company.  Over time, depreciation became an important focus for financial accounting, with the understanding that property costs should be measured against income or revenues during the property’s useful life.

In the United States, depreciation became part of federal tax mandates with the Tariff Act of 1913, which both imposed a corporate income tax, and allowed depreciation deductions. Over the next century, new acts and IRS rules tweaked depreciation requirements, giving us what we have today.

How it Helps Your Taxes

By using depreciation as an expense, it can reduce the amount of taxable income that needs to be reported to the government. That’s the basic explanation. Overall, depreciation is determined by the type of property you own, its value, the economic cycle, and the age of the asset. The more expenses your property generates, the more it can be taken against your income.

Furthermore, depreciation methods can differ. Straight-line depreciation deducts an equal amount of an asset’s cost over the asset’s useful life. Real estate property is depreciated on a straight-line basis over 27.5 years (residential real estate) and 39 years (commercial). Accelerated depreciation, meanwhile, allows you to deduct higher amounts against an asset’s cost basis, early in the asset’s life.

Investor Beware

While depreciation can help lower the tax bite from real estate investing, it isn’t an open invitation to use expenses to lower your income. There are some things to consider with depreciation expense, such as:

Passive income. Depreciation expense can only be used against passive income. Passive income, in turn, comes from an investment property or other enterprise in which you’re not actively participating in operations. Rental income from your real estate investment could be considered passive income.

Depreciation recapture. While the IRS is generous in allowing you to use depreciation expense, it wants that money back when you sell your capital asset. This is called depreciation recapture, and it’ll mean a 25%-28% hit on your capital gains. One way to avoid this is disposing of your real property through a 1031 exchange. 

As with anything that impacts your investment income, be sure you have a skilled tax planner or financial advisor on your side. These individuals can help you understand the impact of depreciation on your tax burden, and can also help you set up methods to better manage it.