Real estate offers investors many different tax-advantaged strategies that can prove beneficial for limiting their annual tax obligations. Depreciation is one of the most valuable tools investors can use to reduce their federal tax liability by deducting or writing off a portion of their annual investment costs during the approved lifespan of commercial real estate assets.
There’s a catch, though. Depreciation can save you money each year through reduced tax bills, but if you sell your commercial property the IRS will want you to pay that money back through a process called depreciation recapture.
Below we’ll outline how depreciation recapture is calculated, or recaptured, and how investors can use a 1031 exchange to defer recapture taxes on their investment properties.
IRS guidelines allow a 39-year depreciation recovery window for commercial properties bought after 1993. That means you can deduct 1/39th of the costs related to acquiring or improving commercial real estate each year for 39 years -- the “useful life” of the property.
It’s important to note that depreciation applies only to commercial buildings and improvements -- the land underneath your investment properties is excluded because it has an infinite lifespan.
Here’s an example of depreciation on a commercial asset costing $1 million:
- Value of asset: $1 million
- 1/39th annual depreciation deduction: $25,641
Using the numbers above, you can reduce the total taxable income on your investment property by more than $25,000 each year. Depending on how much revenue your income-producing properties generate, this crucial deduction could also potentially reduce your overall tax burden by dropping you into a lower tax bracket.
Depreciation deduction also applies to multifamily properties, and residential rentals placed into service after 1986. However, the “useful life” of these assets is lower -- 27.5 years -- so the depreciation deduction is lower as well (1/27.5).
Investors can begin depreciating commercial assets as soon as they are put into service and start generating income. You can continue taking the deduction until the entire basis has been deducted or you sell the property. Here’s the formula used to determine basis and depreciation on commercial assets:
- Cost of your property, minus the value of the land=Basis
- Basis divided by 1/39th=the amount you can depreciate annually
How to Use a 1031 Exchange to Avoid Depreciation Recapture and Maximize Tax Benefits
While depreciation is a valuable tool that can help you reduce your annual tax bill, ultimately, the IRS wants you to pay that money back.
When you sell your investment property, you must report to the IRS the difference between the basis and the sale price of the asset. That profit is taxed -- recaptured -- as capital gains at 28 percent for properties purchased before May 7, 1997, and 25 percent for properties purchased after that date.
There is a way to mitigate what could potentially be an onerous tax liability, though. Investors who sell their commercial assets and purchase like-kind properties through a 1031 exchange can defer the taxes on gains they’ve realized from their disposed properties.
Real estate can be a very tax-efficient investment vehicle. By completing a 1031 exchange, you can potentially maximize the tax benefits of depreciation and mortgage interest deductions while deferring depreciation recapture and capital gains taxes.