Real Estate Investing Basics

Real Estate Depreciation: A Deeper Look

Expertise: Real Estate Investing Basics
15 Articles Written

One of the many benefits of real estate investing is depreciation—the loss in the value of a building over time due to wear and tear, deterioration and age. Depreciation can only be applied to the building, not to the land. After all, land does not wear out over time. Luckily for real estate investors, building depreciation reduces one’s reportable net income and, thus, his taxes. Sounds pretty good, huh? Follow me as we explore depreciation in more depth.

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Real Estate Depreciation Methods

Several different depreciation methods have existed through the years. However, the method one uses is dictated by the property’s type and date of being placed into service. Depreciation for residential income property placed into service after December 31, 1986, for example, is calculated using the “straight line” method over 27.5 years. Depreciation for commercial income property placed into service after December 31, 1986 but before May 13, 1993, on the other hand, is calculated using the “straight line “method over 31.5 years. For commercial income property placed into service on or after May 13, 1993, one uses the “straight line” method of depreciation over 39 years. Remember that depreciation only applies to the building improvements and not the underlying land.

What about property acquired before 1986?

Investors that own property placed into service prior to December 31, 1986 generally use the “Accelerated Cost Recovery System” (ACRS) for depreciation. This method allows an investor to take more depreciation in the early years of a property’s holding period.

Depreciation Recapture

Upon the disposition of an income property, one is required to recapture all depreciation taken over the holding period. Basically, since the IRS allows the taxpayer to deduct depreciation from an individual’s ordinary income, all depreciation taken is subject to recapture at a maximum rate of 25%. If for some reason you are not taking depreciation on your income property, start filing amended tax returns; depreciation recapture is required regardless of whether or not you claimed such depreciation in previous tax returns. The IRS assumes you have claimed such depreciation, so you might as well do it.

Capital Gains vs. Depreciation Recapture

The best way to illustrate this relationship is through an example. Let’s assume Joe Investor has purchased a 20-unit apartment building in June 2004 for $2 million with $50k in acquisition costs. Let’s also assume that the building improvement percentage is 60%. Thus, Joe Investor’s cost basis is $1.025 million. Since this building is classified as a residential income property placed in service after December 31, 1986, it uses the 27.5-year straight line depreciation method. Thus, after a 5-year holding period, the accumulated depreciation on the building is $218,182 (=60% building improvement x $2 million x 5 yrs / 27.5 yrs). Thus, Joe Investor’s new cost basis is $1,831,818 (=$2.05 million – $218,182). If Joe Investor sells this property in June 2005 for $3 million with a 5% cost of sale, Joe would have realized $2,850,000 (=$3 million – 5%) generating a recognized gain of $1,018,182 (=$2,850,000 – $1,831,818). Of this $1,018,182 gain, we know that $218,182 of it is the result of depreciation and is thus subject to a maximum 25% tax. The remaining $800,000 ($1,018,182 – $218,182) gain is subject to a 15% capital gains tax. Of course, you can perform a like-kind 1031 tax deferred exchange, which you can read about here, and avoid paying the capital gains tax.

The above explanations are far from exhaustive, but hopefully it has given you a decent working knowledge of depreciation recapture. Use this information when consulting your CPA regarding your particular real estate investments. Happy investing!

Photo: irisb477

Kyle is a real estate investor and a consultant for Epifany Properties, a company that offers the full gamut of services any Real Estate Investor woul...
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    Tim Hawkins
    Replied over 10 years ago
    Kyle — I didn’t see any comments here about these two issues: 1) Cost Segregation Study; while most companies that do this are only interested in the big commercial buildings, we found one that would do residential for about $650, getting us way more depreciation. 2) land vs. improvement ratio; CPA’s will steer you to a 15% or 20% fixed value that I’ve been unable to confirm in *any* IRS document (ask the CPA find it), and the IRS says you “can” use the tax assessors ratio, but the IRS ATG says FMV and 2 other cost approaches work as well. We use FMV for an increase in depreciation of about $25k/house. Just my 2 pennies…
    Tim Hawkins
    Replied over 10 years ago
    Forgot two more: 1) The investor has to determine a capital expense floor value like $1000 to determine what’s a operational expense and what’s a depreciable capital expense, and then when something that’s being depreciated is replaced the remaining value is expensed, and the replacement begins it’s own depreciation schedule. All that has to be documented, keep all receipts. 2) The investor AND their CPA has to track that depreciation from cradle to grave (I say AND because no matter how good your CPA is, the associate accountant actually doing the work can and will make mistakes, check every single number on your tax return; this has saved us an audit and tens of thousands of shekels).
    Replied over 10 years ago
    Great Article. I love reading all this stuff about the different ways to make, invest and keep the money that you work so hard for. The information that we gather today will help us tomorrow. Thank You [email protected] Mortgages Reply Report comment
    Replied over 10 years ago
    Great Article. I love reading all this stuff about the different ways to make, invest and keep the money that you work so hard for. The information that we gather today will help us tomorrow. Thank You [email protected] Mortgages
    Ralph May
    Replied about 10 years ago
    Looking for information on the sale of corporation with 1.4 mil in depreciation as its only asset. Does any one know where to look for a purchaser? What are the tax laws on a sale of this nature ? Thanks for the input.
    Greg Turnquist
    Replied over 7 years ago
    Don’t forget, depreciation is never lost. If you have more depreciation than you can use in a given year, you get to carry it forward into future years until you CAN use it. It’s possible to accrue enough to possibly offset depreciation recapture or even capital gains at the time of sale. That’s why it’s valuable to find a CPA that has experience doing this type of thing. Not all CPAs are created equal or serve the same customers, i.e. RE investors.
    Replied over 7 years ago
    I don’t think there is any recapture if the depreciation was straight line. You still have to pay capital gains on the accumulated depreciation.
    m kaufman
    Replied over 7 years ago
    Kyle, With a 1031 exchange you don’t have to worry about the recapture as well as the capital gains- from your post (which I enjoyed, thank you) it sounds like only the capital gains you dont have to pay.
    Sharon Long
    Replied about 6 years ago
    How is depreciation taken on a residential property if you are a real estate agent that has purchased the property to flip – not lease?
    Tim Hawkins
    Replied about 6 years ago
    @Sharon; at the time of sale you would have to pay tax based on “depreciation recapture”, so you would generally avoid depreciation on flips (I believe–check with a CPA who is HIGHLY knowledgeable on RE issues. Depreciation is more of a buy and hold strategy. And, if done properly avoids the sale (using 1031 Exchange (tax deferral) or stepped-up basis at death (tax avoidance)) of the property.
    Sharon Long
    Replied about 6 years ago
    Well, that is what I thought, but my accountant has taken depreciation on a property I purchased to resell. It has taken three years to sell it though, so maybe he thought I intended to rent it. – Was a bad market! Thanks for comment.
    John Roll
    Replied almost 6 years ago
    Kyle, thanks for the info. Ir raises a question about depreciation recapture. I’ve accepted an offer for a house I’ve rented since 1999. Assessor data shows land accounted for 16% of total value in 1999, rising to 47% by 2013. My overall capital gain is about the same as the increase in land value. For depreciation recapture, must a seller assume a constant % split of building/land value? If I assumed a linear change from the split of 16% land/84% building in 1999 and the 47/53 split in 2013 would I be out of whack with applicable accounting/tax rules? Thanks for any advice!
    Scott Bartkoski
    Replied over 1 year ago
    If I’m, let’s say, the 4th owner of a house and I buy it when it’s 20 years old, can I still claim the full depreciation as mentioned above, or have the previous owners “used up” that when they owned it? Does each individual investor of a property get to claim the full deduction? Thanks.