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.
How to Invest in Real Estate While Working a Full-Time Job
Many investors think that they need to quit their job to get started in real estate. Not true! Many investors successfully build large portfolios over the years while enjoying the stability of their full-time job. If that’s something you are interested in, then this investor’s story of how he built a real estate business while keeping his 9-5 might be helpful.
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.
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!