There's no doubt about it – one of the greatest benefits of real estate investment are the tax benefits the investor receives! It's entirely legal to shelter income and defer capital gains. It's entirely legal to minimize taxation and maximize the money the investor keeps on an after-tax basis.
The concept of depreciation (also known as cost recovery) operates on the assumption that physical assets lose an equal amount of value each year due to wear and tear. Another term for this is “non-cash expense.” In other words, it doesn't really take any cash out of the investor's pocket. However, it's treated like an expense or deduction when adding up your income.
And the investor gets a great result from this concept – it decreases taxable income and, as a result, lets the investor shelter positive cash flow from taxation. In other words, depreciation (cost recovery) lowers income taxes for the current year and defers them to a later date.
Keep in mind that cost recovery or depreciation does not eliminate income taxes. In technical terms, an annual depreciation deduction is figured on a reduction in basis of the property. This is calculated as the investor’s original cost in the property plus capital improvements. This is then recaptured (added to the investor’s taxable profit) in full and taxed upon disposition or sale.
Currently, all tax deductions taken for depreciation are recaptured and taxed at a maximum rate of 25% when the investor sells the property. Here’s an important point to remember: the land on which the investor has property is not depreciable. In other words, while buildings suffer wear, land doesn’t. Therefore, if the investor wants to enjoy larger depreciation benefits, improvements should be made to the buildings.
The Internal Revenue Service will accept one of two assessments in order to determine depreciation. One is to have a professional appraisal done. However, this can be expensive. The other choice is to have a Comparative Market Analysis (CMA) completed by a broker. A CMA is often done for free or at low cost.
Although there are different kinds of depreciation for real estate, a straight-line method of depreciation is used for tax purposes. Under this method, an equal amount is depreciated each year until the asset has been fully depreciated.
The annual depreciation is calculated by subtracting the salvage value (the estimated value of the property at the end of its useful life) of the asset from the purchase price, and then dividing this number by the estimated useful life of the property.
The recovery period is the period of time during which the depreciation is taken. The IRS has very specific rules for straight-line depreciation. The following regulations apply to properties placed in service or bought on or after May 13, 1993.
- Commercial properties. The recovery period is 39 years (or an annual cost recovery of 2.564%). The IRS classifies mixed-use properties as commercial unless the income from the residential portion is 80% or more of the gross rental income.
- Residential rental property. The recovery period is 27.5 years (or a cost recovery of 3.636% on an annual basis). A property is qualified as “residential” if the tenants stay a minimum of 30 days, and no substantial services are provided (health care, etc.).
The Tax Reform Act of 1984 requires that taxpayers use the 15th of the month to establish the date of acquisition and date of disposition when calculating cost recovery deductions. This is called the mid-month convention requirement.
The act applies to real estate placed in service after June 22, 1984 with the exception of low-income housing. Put more plainly, this means the transaction is presumed to have been completed on the 15th of the month, regardless of the actual day of sale. Therefore, the depreciation deduction is pro-rated, based on the number of full months of ownership plus ½ month for the month of purchase or sale.
As always, investors should consult with their tax advisor.