Real estate assets undergo wear and tear and other factors that can impact their useful life. This opens the door to depreciation, which can help reduce your tax liability while you own investment or business property.
However, not all properties qualify for the tax advantages offered by depreciation. Furthermore, those that do qualify could generate tax liabilities when they’re sold.
Depreciation is an accounting tool that allows you to deduct the cost of your rental or business building over the estimated useful life. The idea is that spreading out the costs over a specific number of years can cover a building’s natural wear and tear. Only buildings are eligible for depreciation; land is not.
Meanwhile, the IRS set up a schedule that helps you determine your property’s depreciation. The annual depreciation rate you can deduct is 3.636% for residential properties. The annual depreciation rate for a residential property is calculated as 100% ÷ 27.5 years = 3.636%. However, the length of time during which you can depreciate your property depends on the asset type. Specifically:
Here’s how this might work.
The above continues until you sell the property or it reaches the end of the depreciation period. Depreciation can be helpful for offsetting gains, as it lowers the property’s tax basis.
The IRS can be generous by offering depreciation deductions on your investment or business property. However, the IRS wants some of that depreciation value back when you sell that depreciated asset and generate gains above the cost-adjusted basis. The give-back is known as depreciation recapture, which is taxed as ordinary income.
Using the same example above, let’s say you bought an apartment complex for $700,000 and depreciated it over five years, resulting in an adjusted basis of $572,740. You put the property on the market and receive $900,000. Meanwhile, your income puts you in the highest tax bracket (24%).
Here’s how depreciation recapture might be calculated:
Then there are capital gains taxes, calculated as follows:
Adding the total depreciation recapture ($30,607.20) to the capital gains tax ($40,000) means you owe $70,607.20 in taxes on the sale.
Depreciation on your investment or business real estate can help reduce yearly income taxes by reducing the property’s cost basis. However, this perk isn’t free–you’ll need to pay it back when you sell the asset. One way to potentially defer depreciation recapture and capital gains taxes is by swapping your property into a like-kind asset through a 1031 exchange. If you decide on this method, reach out to the professionals at Realized 1031 by visiting realized1031.com.
Otherwise, understanding how depreciation works in tandem with real estate (and how depreciation recapture works when it’s time to sell) can help you prepare for this tax liability.
Examples are used for illustrative purposes only.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.