Is Depreciation Really A Benefit to Rental Investor Or a Trap

10 Replies

Hello,

Depreciation is touted as one of the big benefits of buying investment real estate (rentals) . I am not able to understand the benefit of taking depreciation on a rental property. On one hand IRS rules force you to take the depreciation every year and on the other hand when you sell the property all the depreciation you took gets added to your income and you get taxed at 25%. So what is the big benefit here ?. In fact its a nasty surprise to pay a huge tax bill. if you never sell and pass it on to your heirs as step up then it might benefit but if someone wants to just sell and get out of rental business (not do a 1031) it seems like a huge trap.

e.g. Lets say I buy a rental property for $100K and building is valued at $80K. Lets say I take 2K depreciation every year for 10 years. So on total of $20000 of accumulated depreciation over 10 years I save tax = 20000*25/100 = $5000 (say I am in 25% tax bracket). 

Now when I sell the property, the $20000 in accumulated depreciation gets added to my income and I now have to pay tax of 20000*25/100 = $5000 tax on it (25% tax bracket). So whatever $5000 I saved over 10 years in one go I am asked to pay back. Unless I am missing something, what did I really gain here ? A big chunk of your profit will go into paying this if one hasnt kept aside money every year to pay back this depreciation.

Appreciate if anyone can provide insights on this.

Thank you

You are missing three key points

1) The time value of money.  Would you rather pay $1 today or $1.5 at some point on the future?  What if that some point was 10 years or 20 years or 30 years

2) Focus on growth, not one and done. If all you do is buy one property and later sell it, you have the scenario you outlined. But what if you buy one property and then later buy another, then another, then later sell the first one and then buy two more. If you are growing your net worth and growing your assets, you can continually kick the can down the road

3) You can literally never pay the taxes. Once you die, all those recaptured depreciation taxes are wiped out and your heirs inherit the property at a stepped up basis. So, if you do it right, you never pay any taxes.

i would say the benefit is lowering your taxable income today, with funds you “may” pay back at a later date (or not at all)..... so think of it as a “free” loan that you may never have to pay back...



Hello,

Thank you for sharing your thoughts and advise. I agree that if one can afford to keep the property or properties forever and then pass on to your heirs after you die as a step up then they inherit it without this tax and you don't pay anything. If you do sell then there is a option for you to do 1031 and avoid this depreciation recapture tax but it means you once again have to buy equivalent value like minded asset and all the costs involved with sale/repurchase and strict terms and deadlines.

 Unfortunately in today's uncertain world where one job loss or medical problem can put one's health and finances in jeopardy and if  due to emergency you have to sell the property or properties  after holding on say 20 plus years then it becomes a huge burden unless one puts aside that money every year as a contingency. This is especially true if you hold a job and this is just your side investment and  NOT your main BUSINESS. Where folks do it as their PRIMARY business then i guess the terms are more favorable like they qualify for business to be deemed as "passthrough". 

Also what if tomorrow the Govt removes the step up policy ?

What I have realized is getting into investment real estate is easy part. Selling and Getting out is a tough one. The costs/taxes are prohibitive like below if one wants to sell and get out.

1) Around 7-10% costs of selling (Broker fees, lawyer, closing, fix up house, transfer tax to pay etc.)

2) 15% -20 % Capital gains tax on property sale profit depending on your tax bracket for federal level. Plus around 5% -8 % on state/city level

3) 25% Depreciation Recapture tax on federal level. Probably another 5 % on state level also.

4) The depreciation recapture tax when sold gets added to your income and can put possibly raise your income tax bracket (e.g. going from 25 to 30%)

5) if your income rises over a certain threshold, then you have to pay additional 3.8% tax called NIIT on your total investments (shares/dividend/interest) and not just gain of property sale.

Thank you

Originally posted by @Pesi Satarawalla :

Hello,

So what is the big benefit here ?. 

I think the theory is that buying an apartment is a cost of doing business.  If you expensed the price, you'd have tax shelter carry-forward for a long time.

So the IRS says you can take 1/27.5 (apartments) of the price of improvements every year as tax shelter.

I think either way you get tax shelter which is fine.  I understand the recapture, but you can do a 1031 to keep it rolling forward.

 

@Pesi Satarawalla , I think you're absolutely right - Getting out of real estate unscathed isn't easy at all. But it's not impossible. It just takes some planning. And depreciation is exactly what you said - a gift and a trap.

If depreciation is planned for and mitigated through series of 1031 exchanges over the years you've achieved two things - First you've received hundreds of thousands of dollars in tax relief by taking the benefit without having to pay that back.  And secondly, You don't have to pay it back - There's a real reason for the mantra "defer defer defer" and die.  But that's not a mantra for the short game.  That describes a disciplined long term growth and transition as a real estate investor.  But in this instance it's a gift like you can get nowhere else in the tax code - I mean depreciation is the mack daddy of writeoffs - whether real estate or personal property - Huge,,,,Really Big!

But if an investor is someone who doesn't have that focused intent so they can keep depreciation recapture at bay with 1031 exchanges then depreciation is a trap.  Cost segregated depreciation even much more so.

@Greg Scott is my spirit animal!!  And there are so many ways to avoid the tax for life and then in death.  It just takes focus and patience.


Btw @Pesi Satarawalla the reason I am a RE investor now (and happily so) is due to the massive cap gains and depreciation recapture I would of paid had I sold when my father died (yes, I know, step up in basis, but it does not apply to RE held in C corporations and that is how these were held). So, i gritted my teeth and rolled up my sleeves and started my RE investment journey. I am glad I did, now.... but yeah.... there are ramifications.... but that said - RE is still the best chance most of us have for creating real wealth.

Dave, as always thank you for your explanation. I guess with real estate you really need to be in for a long haul and takes lot more focus and planning then most new investors like me realize when getting into it. A majority of folks like me who hold other jobs which take up all your time and just start investing in real estate as another investment avenue have no clue about these complexities. Brokers/CPAs tell you about the depreciation benefits at the start but forget or are silent on recapture and other tax complexities and you learn this the hard way on your own.

That's so often true @Pesi Satarawalla .  That's why I try to be the loudest voice in the choir letting people know that depreciation doesn't have to bite you on the back end of your investing.  Because it is a wonderful tax write off as you go.  It's just when you want to stop that it hurts you. 

This is when the 1031 exchange can help by letting you transition into totally passive investments, property that you later move into, vacation rentals for your golden years that you can rent some and use some, or just properties that you can hold throughout your life so your heirs can get the benefit of that depreciation recapture and tax on gain going away with your death.

So if you want to get the real full benefit of depreciation make a plan that involves never paying recapture.

Below is a example I have put together of a sale of rental property and the taxes / sale fees one can face. This is just from what I could gather and learn from various forums and may not be complete. They eat up more than 50% of your gain

Purchase Price 194500
+ Purchase Costs (** if you are already amortizing them per year then you cant add them at sale time to cost basis) 0
+ Capital Improvements (** if you are already amortizing them per year then you cant add them at sale time to cost basis) 0
+ Sale Costs (Broker Fees, transfer tax, house fixup, lawyer etc) 19400
- Accumulated Depreciation ($6K per year for 5 years) 30000
= Cost Basis (Purchase Price + Purchase Costs + Improvements + Selling Costs - Accumulated Depreciation 183900
Sale Price 240000
Gain (Sale Price - Cost Basis) 56100
Depreciation Recapture Tax
25% at Federal Level on Accumulated Depreciation 7500
5% at State Level on Accumulated Depreciation 1500
Total Depreciation Recapture Tax 9000
Capital Gains (calculated AS 15% on REMAINING BALANCE of Gain - Accumulated depreciation amount)
15 % Federal 3915
5% State 1305
Total Capital Gains Tax 5220
NIIT Surcharge Tax ( Since accumulated depreciation amount gets added to income, it can raise your income level and if the level tips to > 250K then NIIT surcharge kicks in on All your investments income and not just the house gain. Even without the NIIT, just the depreciation being added to income can possibly move you into a higher tax bracket as a result of depreciation)
3.8% Federal Level On Gain 2131.8
?? On State Level (Not Sure if it is charrged on state too) 0
Total NIIT Surcharge 2131.8
Total Taxes To Pay 16351.8
So Total Taxes + Sale Costs (This eats up more than 50% of your gain) 35751.8
*** Any accumulated losses which have occurred over the years and which could not be taken due to income limit can now be taken when selling property