What Is Depreciation, And Why Is It Important?

Posted Dec 27, 2019


Real estate investment is widely considered as an attractive asset class to investors around the United States for a number of reasons. Whether you own an office building in the central business district of Chicago, an apartment building in Charlotte, or a retail strip center in Orlando, real estate can offer attractive risk-adjusted returns. Given conscientious market selection and fluid operation, real estate has the potential to appreciate over time — allowing you to build equity as you reduce debt on the property or portfolio. 

However, one of the most unique and attractive aspects of real estate investment is the tax benefits associated with the asset class and the opportunities investors have to reduce taxable liabilities via mortgage interest payments and depreciation deductions. While interest payments are relatively straightforward (a taxpayer with real estate holdings can deduct the sum of mortgage interest payments associated with a property over the course of a year from taxable income), depreciation is slightly more complicated. 

Depreciation Defined

In the context of real estate investment, depreciation is an income tax deduction granted by the IRS that allows for recovery of the cost of property or assets “placed into service” as a source of rental income. Thus, depreciation can be recorded at the time a property is placed into service or rented and ends when tenants vacate, or you dispose of the asset. 

There are three factors in play when calculating depreciation allowance:

The depreciable basis on the property: How much is the property worth to the IRS? Typically, this number is going to be what you purchased the property for (minus land value). In a 1031 exchange, however, the depreciable basis is going to be the purchase price of the replacement property less the deferred realized gain. The annual depreciation amount one can take on investment property is a function of this cost basis, and when a property or fixed asset is depreciated, its basis is reduced regularly over its useful life.

The recovery period: The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation system used by regulators and investors in the United States. Under MACRS, assets are assigned to a specific class with a particular depreciation period published by the Internal Revenue Service (IRS). Recovery periods for various types of fixed assets are listed below:

  • Appliance, carpeting, furniture: 5 years
  • Furniture and equipment: 7 years
  • Fences and roads: 15 years
  • Residential real estate: 27.5 years
  • Commercial real estate: 39 years

The depreciation method used: 

MACRS depreciation is the tax depreciation system used in the United States. In some cases, businesses are able to employ an accelerated depreciation method which allows for faster depreciation in the earlier years of an asset’s life and decelerating deprecation later in the recovery period. Taxpayers can choose to record depreciation by the straight-line method or the accelerated method.

It is important to note that land cannot be depreciated because it is assumed to have an unlimited useful life. When determining the depreciable value of an entire property (land and improvements), it is critical to deduct the value of the land from the depreciable basis.

Depreciation and Taxes

Perhaps the most crucial aspect of depreciation for investors is its tax benefits. Depreciation allows taxpayers to reduce taxable income. Because it is considered a passive loss, depreciation expense can only offset passive income, which includes income generated from rental income from real estate holdings, stock dividends, and other fixed-income securities such as corporate or municipal bonds. 

To better understand how a taxpayer can reduce taxable income, we will walk through how you would calculate your depreciation expense after purchasing a piece of property or a secondary residence. Let us assume you purchase a home for $500,000. At the time of purchase, you hire a third-party appraiser to assess the value of the land on which your home stands. The appraiser indicates to you that the value of your land is $100,000, meaning the value of the actual structure is $400,000. Assuming you use a straight-line depreciation method, you will calculate your annual depreciation expense by dividing the value of your home ($400,000) by 27.5 (the depreciation period the IRS assigns to residential real estate under MACRS). By this calculation, you arrive at your annual depreciation expense of $14,545. Multiply this depreciation expense by your marginal tax rate, and you will arrive at your annual tax savings.

When it comes time to sell an asset you have been depreciating over its useful life, be wary of the tax implications of your disposal. The IRS employs a procedure known as depreciation recapture to collect taxes on the portion of the realized gain attributable to depreciation. Collection occurs at the time the taxpayer disposes of an asset that previously allowed for the reduction of taxable income via depreciation deductions. Check out the example below: 

Imagine that an investor acquired an apartment building for $1 million (excluding land). After 10 years, the owner has taken $363,000 of depreciation deductions, which means the investor’s new basis in the building is now $637,000. If the investor sells the building for $2 million, they will recognize a gain of $1.363 million ($2 million less $637,000). Most would think that the $1.363 million would be taxed at a capital gains rate of 20% — however, in this example, $363,000 of the gain would be taxed at the recapture rate of 25%. The remaining $1 million gain would be taxed at the 20% capital gain rate. This would result in $18,150 of additional taxes. The greater the transaction and the greater depreciation amount taken, the larger this additional tax cost will be.

But here's some good news. Even if recaptured, depreciation shelters income from taxes. Depending on the investor's tax bracket, income tax rates are as high as 37% — but the depreciation recapture tax rate is flat at 25% — meaning that when it does come time to pay taxes on depreciation taken, it may be taxed at a lower rate than the income it sheltered. 

What's more, an investor has the opportunity to defer this depreciation recapture tax by participating in a 1031 exchange, which is a type of transaction that allows an investor to reinvest proceeds from the disposal of an asset while simultaneously deferring capital gains taxes and depreciation recapture. 

The Bottom Line

Real estate investors can build equity in an asset that has the potential to appreciate over its useful life, simultaneously offering the potential for attractive, risk-adjusted returns. Depreciation allows investors to measure the value of their assets at the time of acquisition and reduce tax liability over the useful life of the asset. Additionally, the use of leverage allows for even greater tax benefits through mortgage interest deductions. With the chance to depreciate holdings and further enhance cash flow via tax savings, it’s safe to say that real estate can be an attractive investment for those who manage it wisely. 

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