Is Depreciation Important?
Steve RozenbergPro Member
Specialist · Houston, TX · Member since 2015 · 1k+ posts · 1k+ votesHow Important is Depreciation in Buying an Investment Property?
@Steve Rozenberg - Oh man is this right in my wheelhouse. Get ready to learn the good, the bad, and the ugly about depreciation as it pertains to your question. I am a CPA who has done work for hundreds of real estate investors over the past 13 years, and I own and rent a series of residential and commercial units here in sunny, scenic South Jersey and (until recently) in Texas. Ready? Here we go:
So folks have already covered many of the depreciation basics. Here's a great rule of thumb.
The difference in #1 and #2 is because when you bought your house, you also (usually) bought some land, which cannot be depreciated because land is good forever, so there's an allocation factor to exclude a standard amount for the land.
Example: $150K purchase provides $4800 annual depreciation . That's $400/month. So you can have taxable income of up to $400 every month and pay no tax.
Folks have explained correctly that you take your depreciable basis over 27.5 years; 1/27.5th each year (3.64%). The reason is because of an IRC concept called the matching concept, in which you match expenses to the period in which they occur. For example, when you pay the July water bill, you deduct it in the current year, because it happened that year. (Although the IRC says it in a much more confusing way: "You derived substantially all the economic benefit during the current period") And when you paid the first quarter R/E taxes, you write that off in the current year. And the tenant ad you ran, and so on. However, the economic life of the house will last you more than one year (hopefully) and hence that 27.5 year rule.
After that you can jack up the depreciation by doing cost segregation. We do that for our clients, when we break the house up into shorter depreciation lives, mostly 5 or 15 years. This is an aggressive method, so it needs to be properly documents. We use a list of 64 things that can be depreciated over 5 years, each one substantiated by a court case, a Revenue Ruling or a Private Letter Ruling. Same thing for 15 year property. Front loading the depreciation accelerates your write-offs, because who knows if you're gonna hold your property all 27 years?
Effective tax planning features taking advantages of write-offs in the year possible, and cost seg is a great way to do it.
Now its not all riches. The depreciation lowers your cost basis, so there will be more gain when you sell it but so what? Its not an even Steven trade off. I mean you're taking depreciation annually, and its saving you tax at some incremental rate - 25%, 28%, 31%, etc but when you sell it and have a big gain, that gain is taxed at long term capital gains rates, which for most folks is only 15%! Yes you pay some tax on the recapture of the depreciation at 25% as some folks will be quick to point out, but the savings that you got annually while renting it still exceed the tax you pay at the sale.
Be careful though. There is a nasty rule in the IRC (Internal Revenue Code) that says you must recapture all the depreciation that was allowed, or WOULD HAVE been allowed. I have come across more than one client who said "I don't want to depreciate the property, so I can keep a high basis and less gain on the sale". I am forced to tell them, "Sorry, but nice try". Then again, there's a little loophole in that case whereby I can make a cumulative adjustment this year for all the depreciation not taken previously, but that's another post this long for another day. Just know there are often solutions in the tax code, if you know where to look.
If you made it this far and are still awake, then if you have any more questions, let me know.
Jim Kennedy, CPA
It's very important. It certainly adds up and can help in the reduction of your taxable income. Of particular note is the fact that whether or not you take advantage of the deduction each year, the IRS is going to handle it as if you did when you sell it and it comes time for depreciation recapture. So let's say you buy the house now and hold it for 20 years. A property is depreciated over 27.5 years. So each year, you can depreciate 1/27.5th of it and use that to offset taxable income. When you go to sell it in after 20 years, the IRS is going to handle that as if you took that depreciation every single one of the previous 20 years. So you might as well take it if they're going to count it regardless!
Depreciation typically is the largest expense on your taxes and the best thing about it is it's a non-cash expense so it costs you nothing. Deprecation helps alot when you're trying to stay away from higher tax brackets.
@Steve Rozenberg Very important, especially when buying property with debt financing.
Yes I agree, for me I have a regular job of being an airline pilot as well as owning investment property and a property management company. For me the depreciation and carry forward is a huge help against my W2 earnings. I would never buy a deal or decide to or not to move forward because of depreciation but I certainly think it needs to be factored into the overall equation and validity of a deal when doing your due diligence.
@Steve Rozenberg - Oh man is this right in my wheelhouse. Get ready to learn the good, the bad, and the ugly about depreciation as it pertains to your question. I am a CPA who has done work for hundreds of real estate investors over the past 13 years, and I own and rent a series of residential and commercial units here in sunny, scenic South Jersey and (until recently) in Texas. Ready? Here we go:
So folks have already covered many of the depreciation basics. Here's a great rule of thumb.
The difference in #1 and #2 is because when you bought your house, you also (usually) bought some land, which cannot be depreciated because land is good forever, so there's an allocation factor to exclude a standard amount for the land.
Example: $150K purchase provides $4800 annual depreciation . That's $400/month. So you can have taxable income of up to $400 every month and pay no tax.
Folks have explained correctly that you take your depreciable basis over 27.5 years; 1/27.5th each year (3.64%). The reason is because of an IRC concept called the matching concept, in which you match expenses to the period in which they occur. For example, when you pay the July water bill, you deduct it in the current year, because it happened that year. (Although the IRC says it in a much more confusing way: "You derived substantially all the economic benefit during the current period") And when you paid the first quarter R/E taxes, you write that off in the current year. And the tenant ad you ran, and so on. However, the economic life of the house will last you more than one year (hopefully) and hence that 27.5 year rule.
After that you can jack up the depreciation by doing cost segregation. We do that for our clients, when we break the house up into shorter depreciation lives, mostly 5 or 15 years. This is an aggressive method, so it needs to be properly documents. We use a list of 64 things that can be depreciated over 5 years, each one substantiated by a court case, a Revenue Ruling or a Private Letter Ruling. Same thing for 15 year property. Front loading the depreciation accelerates your write-offs, because who knows if you're gonna hold your property all 27 years?
Effective tax planning features taking advantages of write-offs in the year possible, and cost seg is a great way to do it.
Now its not all riches. The depreciation lowers your cost basis, so there will be more gain when you sell it but so what? Its not an even Steven trade off. I mean you're taking depreciation annually, and its saving you tax at some incremental rate - 25%, 28%, 31%, etc but when you sell it and have a big gain, that gain is taxed at long term capital gains rates, which for most folks is only 15%! Yes you pay some tax on the recapture of the depreciation at 25% as some folks will be quick to point out, but the savings that you got annually while renting it still exceed the tax you pay at the sale.
Be careful though. There is a nasty rule in the IRC (Internal Revenue Code) that says you must recapture all the depreciation that was allowed, or WOULD HAVE been allowed. I have come across more than one client who said "I don't want to depreciate the property, so I can keep a high basis and less gain on the sale". I am forced to tell them, "Sorry, but nice try". Then again, there's a little loophole in that case whereby I can make a cumulative adjustment this year for all the depreciation not taken previously, but that's another post this long for another day. Just know there are often solutions in the tax code, if you know where to look.
If you made it this far and are still awake, then if you have any more questions, let me know.
Jim Kennedy, CPA
@Jim Kennedy Great insight Jim, I can tell you are definitely in a league of your own in knowledge. Good to hear that information. I completely agree with all that you said. Thanks
@Steve Rozenberg, Thanks for yourkind comments. I see you're on the southeast side of Houston, off of 45. Though I'm in Southern NJ, we owned a couple SFH's in Houston, on the opposite side from you - in NW Houston - in Cypress, off of West Rd and off of Telge Rd. for almost ten years. We got tired of maintaining them, so we sold 'em to the tenants. If I knew you were in Houston, we might have still been owning then. Dang - I knew I shoulda joined BP earlier....
Jim Kennedy, CPA
@Jim Kennedy Never say Never Jim, you may be back!. We manage over 600 homes here in houston and just opened 6 other houston location offices. One is in Cypress
@Samantha Klein, Re depreciation being the biggest expense, I had to chuckle. Your statement is correct, unless like me, you're from NJ. We get hammered. NJ is the first or second highest state in the union (with CT). For us, depreciation is the second highest expense.
@Steve Rozenberg from a lending perspective depreciation is one of the line items that a conventional loan can give back to you in the form of income. For example, if you net $0 on a property (after all your deductions) but your have depreciation of $1000 then a conventional loan will count that property of netting you $1000. If you have depreciation listed on your tax returns then it will help with getting you qualified for a conventional loan.
@Steve Rozenberg Right in Cypress? Thats good news! The SFH's didn't appreciate a whole lot, but they cash flowed well. Sometimes our family in Cypress helped us co-manage, but that too became a headache as we didnt want to wear our welcome out with them. I'll let Management (my wife) know you're in town now because she occasionally hints that she wants to get back into the Texas game. Sounds like you guys are rockin' it!
Jim Kennedy, CPA
@Steve Rozenberg - Oh man is this right in my wheelhouse. Get ready to learn the good, the bad, and the ugly about depreciation as it pertains to your question. I am a CPA who has done work for hundreds of real estate investors over the past 13 years, and I own and rent a series of residential and commercial units here in sunny, scenic South Jersey and (until recently) in Texas. Ready? Here we go:
So folks have already covered many of the depreciation basics. Here's a great rule of thumb.
The difference in #1 and #2 is because when you bought your house, you also (usually) bought some land, which cannot be depreciated because land is good forever, so there's an allocation factor to exclude a standard amount for the land.
Example: $150K purchase provides $4800 annual depreciation . That's $400/month. So you can have taxable income of up to $400 every month and pay no tax.
Folks have explained correctly that you take your depreciable basis over 27.5 years; 1/27.5th each year (3.64%). The reason is because of an IRC concept called the matching concept, in which you match expenses to the period in which they occur. For example, when you pay the July water bill, you deduct it in the current year, because it happened that year. (Although the IRC says it in a much more confusing way: "You derived substantially all the economic benefit during the current period") And when you paid the first quarter R/E taxes, you write that off in the current year. And the tenant ad you ran, and so on. However, the economic life of the house will last you more than one year (hopefully) and hence that 27.5 year rule.
After that you can jack up the depreciation by doing cost segregation. We do that for our clients, when we break the house up into shorter depreciation lives, mostly 5 or 15 years. This is an aggressive method, so it needs to be properly documents. We use a list of 64 things that can be depreciated over 5 years, each one substantiated by a court case, a Revenue Ruling or a Private Letter Ruling. Same thing for 15 year property. Front loading the depreciation accelerates your write-offs, because who knows if you're gonna hold your property all 27 years?
Effective tax planning features taking advantages of write-offs in the year possible, and cost seg is a great way to do it.
Now its not all riches. The depreciation lowers your cost basis, so there will be more gain when you sell it but so what? Its not an even Steven trade off. I mean you're taking depreciation annually, and its saving you tax at some incremental rate - 25%, 28%, 31%, etc but when you sell it and have a big gain, that gain is taxed at long term capital gains rates, which for most folks is only 15%! Yes you pay some tax on the recapture of the depreciation at 25% as some folks will be quick to point out, but the savings that you got annually while renting it still exceed the tax you pay at the sale.
Be careful though. There is a nasty rule in the IRC (Internal Revenue Code) that says you must recapture all the depreciation that was allowed, or WOULD HAVE been allowed. I have come across more than one client who said "I don't want to depreciate the property, so I can keep a high basis and less gain on the sale". I am forced to tell them, "Sorry, but nice try". Then again, there's a little loophole in that case whereby I can make a cumulative adjustment this year for all the depreciation not taken previously, but that's another post this long for another day. Just know there are often solutions in the tax code, if you know where to look.
If you made it this far and are still awake, then if you have any more questions, let me know.
Jim Kennedy, CPA
Real solid stuff here Jim!
@James Masotti - thank you very much for your kind words. I love talking about this, I love teaching it, but most of all I love doing it. Actually my wife is the one who got the bug originally, and then I joined in. We learned to play our strong suits - I excel at getting financing (I once gave a three hour lecture on how to get financing for SJREIA) and my wife is a master negotiator. Then we play good cop bad cop to manage the tenants. I'm a very very by-the-lease guy, and my wife is the good cop - she is physically petite and very quiet and soft spoken (except when negotiating)
Jim Kennedy, CPA
Jim,
I have rented out a SFH for 5 years WITHOUt taking depreciation in Maine. I will probably sell in 2 years. Are you saying I should take the depreciation from the previous years now or when I sell? I just didn't want the recapture but didn't realize what you mentioned above about the IRS thinking its depreciating no matter what. Thanks for your input.
Let's assume you are in an income tax bracket of less than %25....Say 15%. If you depreciate your property for a year and then sell it you have to pay %25 recapture tax? That sucks, you get to pay %10 more in taxes
But for higher incomes it helps to defer taxes similar to how a 401k defers. Keyword is defer. I don't believe it helps a much as people think. You aren't saving $3000, your just not paying taxes on that amount....Yet.
I don't look at it in any calculations. I also have a net income from my properties after accounting for depreciation.
I agree with @William Murrell. Take advantage of every tax break real estate affords you. And, as he aptly points out, the IRS is going to get it eventually so you might as well claim it. Appreciation, cash flow, mortgage paydown and appreciation (in no particular order) are the big 4 in my book.
Its not a primary consideration for me when buying. And unlike some other postings is often not the biggest expense item either. Last year bought a rental property for $20,000, (though previous sale was $105,000), so when you take out the land value and depreciate over 27.5 years there's not much depreciation deduction. Also have bought other recent houses for $34,000 (previous sale $95,000), and $36,000 (previous sale $108,000).
Also we buy lots of lots and land which have ZERO depreciation.
Therefore depreciation is not that big an issue. Now if you are investing in a high price area and buying $500,000 properties, its a whole different story.
But depreciation is always a two edged sword. When you sell the depreciation recapture tax is 25% which is higher than that the long term capital gains tax at the Federal level. So what the tax code giveths, the tax code also taketh away. Some might want to lower the depreciation schedule so that the capital gains is greater and taxed at 15% than the recapture taxed at 25%. Just saying.
Leverage and taxes are two yuge benefits of real estate over other asset classes and also two of the most misunderstood aspects. The tax code is designed to drive economic activity and things like depreciation and cost segregation do exactly that...they encourage the acquisition/transaction of assets (which benefits the buyer, seller, broker, appraiser, surveyor, environmental engineer, inspector, lender, contractors...the list goes on and that creates exponential tax revenue over the original tax-preferred transaction).
Leverage and taxes work hand in hand. You can either have an annual $6k depreciation deduction on a $200k property purchased for cash or a $24k depreciation deduction on four $200k properties purchased with 75% leverage. Even better, have very large depreciation deductions in years 1-7 on one $800 property purchased with 75% leverage and using cost segregation (and then 1031). The deal analyzer spreadsheet should not end with the pre-tax return.
The effective tax rates for many real estate investors (especially commercial ones with the benefit of cost segregation) can be very low (or 0%). When people talk about the efficiency of commercial real estate, this is the kind of real stuff they are referring to and it's much more than just having units all in one location. The tax efficiency and after-tax ROI is a big part of it.
I highly recommend that you read "What Every Real Estate Investor Needs to Know About Cash Flow' by @Frank Gallinelli
You can purchase it here:
https://www.amazon.com/Estate-Investor-Financial-M...
This is a must read for anyone who is serious about REI and will answer questions like the one you asked about depreciation.
Thank you Frank for sharing your knowledge!
Hey Cary-- thanks for the kind words!!
Frank
@Cary F. - Only because I'm annoying. If you are going to recommend buying @Frank Gallinelli 's book from Amazon (or anything else you buy from Amazon for that matter) you should be sure to use AmazonSmile. If you do 1% of the purchase price goes to the charity of your choice, so long as they are a 501(c)3 organization and are registered with AmazonSmile.
Also - Frank you should come out with an Audiobook for those of us who live in our cars and do most of our "reading" on the road.
It's tremendously important. Real estate is one of the few (if not only) assets that allows the owner to depreciate an asset that historically appreciates over time.
@James Masotti Actually, McGraw-Hill told me at one point that they were going to do an audio version of the third edition of my cash flow book. After a while, they realized that there was no way anyone could recite the pro formas I display as examples so they ditched that plan. I have done a pretty extensive video course, however, with my very own dulcet tones as the voiceover--- you could listen in the car, but only if you promise you won't look at your smartphone's screen while you're driving 😲 -- or maybe take the train instead?
@James Masotti Actually, McGraw-Hill told me at one point that they were going to do an audio version of the third edition of my cash flow book. After a while, they realized that there was no way anyone could recite the pro formas I display as examples so they ditched that plan. I have done a pretty extensive video course, however, with my very own dulcet tones as the voiceover--- you could listen in the car, but only if you promise you won't look at your smartphone's screen while you're driving 😲 -- or maybe take the train instead?
Other publishers just come out with an online compendium so that people with the audio book can refer to those things online once they are in a position to get to a computer.