EXPLAINED: Depreciation - myths & reality

[Michael Plaks]

Years ago, I was at a CPA conference, and the lecturer finished 30 minutes early. Unheard of, I know, but it did happen. He asked us what we wanted to learn in the remaining 30 minutes. And 300 CPAs in the room almost in unison chanted: depreciation!

The point of this story is that even we tax professionals are confused by depreciation. Don't feel dumb if you are confused, too. This post has an ambitious goal of dissipating some of this confusion. I do realize that it may accomplish the opposite.

Starting concept: expenses vs assets

Business owners pay for a lot of stuff. Some of that is ongoing and relatively cheap, like office supplies, Internet or insurance. For tax purposes, these are considered expenses which are fully deductible right away.

Other costs are also ongoing but could be significantly higher, such as employee salaries, office rent or interest on loans. These, too, are fully deductible expenses. 

And then there're major purchases that you make once in a while and use in your business for many years. Examples are: construction equipment, vehicles, and rental properties. The tax law calls them assets and does not allow you to deduct their full cost right away. Instead, you are forced to depreciate them: chop it up into multiple pieces and deduct one such piece per year. 

Short layman's version: Assets are something expensive that serves your business for multiple years. You deduct their cost over multiple years via depreciation.

Calculating depreciation

Don't try this at home. Even we accountants stopped calculating it by hand years ago. Why? Because it is maddeningly complicated. It's what tax software is for.

To start, we need to determine the "life" of the asset. This is a bizarre concept that our wise legislators came up with while trying to make their random depreciation periods appear less random. They said: let's spread depreciation over the number of years that this asset should last. And so they decided, for example:

- off-the-shelf software is going to last 3 years

- computers, automobiles and appliances are going to last 5 years

- construction equipment and office furniture is going to last 7 years

- parking lots and fences are going to last 15 years

- residential building, both houses and apartments, are going to last 27.5 years

- commercial building are going to last 39 years

Don't try to make sense out of these weird decisions. They sure didn't try when they made them. But we're stuck with them now. We have to depreciate our assets over these prescribed numbers of years.

It gets worse. If something is depreciated over 5 years, you would think it to be 1/5 th (or 20%) for each of the 5 years, wouldn't you? Nope. 20% indeed in the 1st year, but then 32%. 19.2%, 11.52%, 11.52% and finally 5.76% in the 6th year of a 5-yr period. Don't ask. If you care to know, there're alternative sets of percentages that you can elect instead of this one. Besides, this was based on a "half-year" convention, while you also have mid-month and mid-quarter conventions, the latter one having 4 versions.

The IRS kindly offers you their Publication 946 which "explains" depreciation on its 111 pages, half of those being small print tables. Enjoy. Or keep your sanity and use software.

Instant depreciation: Section 179 and Bonus depreciation

As a welcome reprieve from this depreciation madness, the IRS sometimes allows you to eat the entire pie in one sitting. There're two options: Section 179 and Bonus depreciation. Both of them have been modified countless times over the years and will definitely continue to be tinkered with. Both of them have a confusing set of conditions and restrictions attached, also frequently modified. It's easier to memorize the Starbucks menu or the NFL rosters.

Section 179 basics

- can deduct 100% of the cost in the 1st year

- applies to 3-yr, 5-yr, 7-yr and 10-yr assets and "qualified improvement property" (a separate post would be needed to explain)

- cannot create a net loss

- minimum 50% business use required

- other limits and restrictions apply

Bonus depreciation basics, as of today (mid-2023)

- 100% of the cost in 2022, 80% in 2023, 60% in 2024, and so on until 0% in 2027

- applies to assets with up to 20-yr life

- can create a net loss

Both methods have their pros and cons, and choosing between them, as well as generally optimizing depreciation, is a job for an experienced accountant.

Cost segregation

What cost segregation accomplishes is extracting faster-depreciation property (as in 5-yr, 7-yr and 15-yr) out of slow-depreciation real property. Then you can apply Section 179 or Bonus depreciation to these extracted types of property for a massive instant boost to your depreciation deduction.

While it sounds wonderful, and it does often accomplish exactly this result, there're pitfalls and myths. Cost segregation is not always helpful. I wrote a long post about it a few months ago: https://www.biggerpockets.com/...

Depreciation recapture

The idea behind depreciation is that any asset eventually becomes worthless. Which is why you're allowed to write off its entire cost, either through regular slow depreciation or through Section 179/Bonus depreciation trick. In other words, assets are supposed to lose value with time, and depreciation reflects this expected result.

Here is an example of when it works as intended. You buy $5k worth of new office furniture and start depreciating it over 7 years. (Yes, you could use Sec 179 or bonus, but let's just follow this hypothetical example for now.) Over the first 2 years, depreciation tables let you deduct approximately 40% of the cost, or $2k. At that time, thanks to Covid, you decide to close your office and sell the furniture on Craigslist. Somebody buys it from you for $3k. In this scenario, there is no gain and no loss for tax purposes. You paid $5k originally, recovered $2k of it through depreciation deduction and recovered the remaining $3k when you sold it. All good.

Next, let's modify this example and apply bonus depreciation. Now you deduct $5k bonus depreciation right away. When you sell the furniture later for $3k, you will have $3k of taxable income! In technical terms, you have $3k of taxable "depreciation recapture." If it sounds unfair to you, it should not. You took advantage, tax-wise, of the entire $5k original cost. $3k of that was later "reimbursed" by your buyer. In essence, the furniture only cost you $2k out of pocket in the end: $5k you paid for it minus $3k you sold it for. So, you spend $2k but deducted $5k. This is why you now "recapture" the other $3k and pay taxes on it.

Depreciation recapture catches people off-guard in two very common situations:

A. Trading in a business vehicle. You buy a Ford truck for $50k and use Section 179 to write $50k off. 3 years down the road, it's falling apart, and you need a new truck, because, well, it's a Ford. Luckily, they give you a $15k trade-in allowance for it. Unluckily, you now owe the IRS taxes on $15k depreciation recapture. 

B. Selling a rental property. Remember, the whole depreciation idea assumes that the asset loses its value with time. Clearly, the legislators are not real estate investors. Otherwise they should have known that real estate goes up over time, not down. So you buy a $100k property, depreciate $20k of it over the next few years and sell it for $150k. You expect to pay capital gain tax on the $50k appreciation of the property. What you probably do not expect is to also pay a depreciation recapture tax on the $20k, in addition to capital gain tax. And the rates on depreciation recapture are your regular tax rates (up to 25%), as opposed to the much lower capital gain tax rates of 15% (or even 0% sometimes).

Depreciation of financed assets/properties

Say you bought a $100k rental house for cash. You have to subtract the land value and depreciate the building over 27.5 years. This gives you about $3k per year in depreciation deduction.

Where depreciation gets really confusing is with financing. If you put $10k down and are making payments on your $90k mortgage - how does depreciation work? Answer: exactly the same as if you paid $100k cash. 

You do not deduct your $10k down payment. You do not deduct the principal portion of your mortgage payments. But you do deduct $3k depreciation per year. Same as if you paid all cash.

But you have mortgage costs! Yes, and you do get to deduct mortgage interest. You also get to slowly deduct points, origination, and all other costs of getting a loan via multi-year amortization - a concept very similar to depreciation. What you do not deduct is your down payment and your mortgage principal payments. Instead, you deduct depreciation. When the dust settles, it ends up being the same result.

And now, to depreciation myths.

Myth 1: depreciation is a phantom or "paper" expense

True, you don't write a check or make a Zelle payment for depreciation. Yet, you're allowed to treat it as if you actually paid for it. Which makes it a fake expense of some sort, right?

This is misleading. You actually did pay for it. Remember - depreciation is nothing other than writing off the initial cost of the asset, in this case a house. If you paid $100k cash for the house, you merely write it off as $3k per year depreciation instead of the whole $100k at once. 

What creates confusion is financing, because most properties are bought with loans. When you only brought a small amount to closing, and sometimes even received cash at closing, it may feel like you did not invest money in the property. Then depreciation feels like something for nothing. 

Wrong thinking from a taxman's point of you. You did pay $100k for the house. You simply paid it with other people's money, and now you owe those people or banks. But tax-wise, you paid, and you recover it now via depreciation. Financed properties are depreciated identical to cash properties.

Myth 2: depreciation is a freebie

Freebie is something you never have to pay for. Depreciation, on the other hand, is a loan. Just like with any loan, you have to pay it back.

When? When you sell the property! It's called depreciation recapture, and we discussed it earlier in this post.

You know who is constantly duped into ignoring this simple and important principle? Syndication investors. Every syndicator's presentation stresses how much losses they can create for their passive investors through the magic of depreciation and cost segregation. It sounds very appealing, especially to high-income professionals desperate to cut their tax bill. What the promoters conveniently omit is the fact that ALL of these depreciation deductions, including those obtained with cost segregation, will be reversed in the final year of the syndication when they sell their property. More on myths of syndicate taxation is in this post: https://www.biggerpockets.com/...

Bonus point: 1031 exchanges, QOZ funds and installment sales allow you to defer both capital gains AND depreciation recapture. It's not available to syndication investors though, except for QOZ funds, and QOZ deferral benefits are minimal by now anyway.

Myth 3: PAL (passive activity loss) rules can prevent depreciation

This is not a post on PAL rules. These rules restrict losses from rental properties and syndications. For example, if you're making $150k or more from your W2 job and have a rental portfolio that shows a net loss after all deductions, including depreciation - you normally cannot take these losses against your W2 income. Instead, your losses are carried forward into future years, until your property is sold or some other event unlocks these losses.

The problem is that very often these PAL rules are described as blocking depreciation at the $150k income level. No, depreciation is not targeted by PAL rules. Losses are. Let's say your rent income from your property is $15k, and your deductible expenses are $14k. What do you do with your $3k depreciation if you're under PAL rules? You still take it! The first $1k of depreciation will drop your net rental income to $0. The other $2k of depreciation would create a $2k loss, but PAL prevents you from taking this loss. Well, you have to roll this $2k loss forward to the next year.

PAL or not, you are still allowed to take depreciation, but the resulting loss may be unavailable this current year. In fact, not only are you allowed to take depreciation under PAL, you must do so! Which bring us to...

Myth 4: depreciation is optional

Why take depreciation if you're under PAL and already at $0 net income without depreciation? Better still, why take depreciation if you're supposed to return it back via depreciation recapture when you sell? Good questions.

We may try to debate whether taking depreciation is required by law. What is not debatable however is that we are required by law to take depreciation recapture. And we're required to take depreciation recapture whether or not we took depreciation prior to that! Huh?

Illustration. I offer you $100 as a loan for a week. You say - no thanks, I'm good. I say - no problem, it's up to you whether you accept my $100 or not. But one week from now, I'm coming to collect $100 from you either way. And I'm saying it in Tony Soprano's accent. Are you taking my $100 now?

This is how depreciation works, too. Skip on it if you wish, but Uncle Sam/Tony will collect depreciation recapture from you either way. So better think it through.

Myth 5: you need to amend your old tax returns to fix wrong or missing depreciation

I'm glad I convinced you that you needed to take depreciation which you have not been taking. Why not? Because it seemed unnecessary to you until this post. Or you decided to save money on hiring a real estate accountant and had your cousin who moonlights for H&R Block do your taxes for a few beers. And turns out he never heard of depreciation. Now what? 

Normally mistakes on tax returns are fixed by redoing ("amending") old tax returns. Not depreciation mistakes though, if they existed for more than one tax year. You have to fix it with a much more complex process called "change of accounting method", filing Form 3115 and a special calculation attached to it. The form is 8 pages long, with 34 pages of instructions. Not recommended as a DIY project or as a research project for a non-real-estate CPA.

I could have continued with a few more myths, but my focus has depreciated over the last couple hours of writing this post, so let me go recapture some energy.