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Real Estate Depreciation: Reduce Your Taxes with This Powerful Concept

Every once in a while, the concept of real estate depreciation will come up in news headlines. Thanks to the mathematics behind real estate taxation, there will be some story about a person or company that did not have to pay taxes in specific years. Even if the article itself doesn’t specify what’s happening, more often than not the reason why real estate investors can “avoid” taxes is through depreciation. For those not in the real estate or accounting, this term may be unfamiliar – but it is one of the many powerful concepts behind real estate that make it such an attractive investment.

Whether you’re investing in a apartment complex or a single-family home to rent out, real estate depreciation is probably a way for you to pay less in taxes each year. Here’s what you need to know to avoid inadvertently giving Uncle Sam too much of your hard-earned money!

What Is Real Estate Depreciation?

Depreciation is the decrease in value of an asset over time. Real estate depreciation refers to a tax deduction that allows a taxpayer to recover the cost of a depreciating real estate asset.

When you buy real estate, you’re purchasing two things (usually): land and a structure.

The land’s value can go up and down, but it never deteriorates. That is, fifty years from now, the land will still be as good as when you bought it on day one.

The building, on the other hand, deteriorates. A building might only have a useful life of 30 years before it needs significant repairs. Some may last 100 years, others may last less, but from the moment you purchase the actual structure on the land, its value is on the decline because it will accumulate wear and tear.

That decline in value is called depreciation. It’s a common accounting concept that applies to any real estate structure that produces income.

How Does Depreciation Affect Investor’s Taxes?

There are many tax advantages to real estate, and one of them is how the IRS and Congress treat depreciation for these real estate assets.

With depreciation, you can deduct the cost of buying and improving the property over the useful life of the property. That depreciation “cost” is deductible from your rental income.

As a quick example, let’s suppose you buy a $200,000 home with a structure worth $100,000 and land worth $100,000. Referring to the guidelines, you discover that you can depreciate 3.485% of your rental property in the first year. That works out to $3,485.

You would list all your income – let’s say $12,000 – for the year on your Schedule E. You would also put your expenses – let’s say $9,000 – on the same form.

Without depreciation, you would owe tax on that $3,000 profit. But, since you calculated the depreciation, you would add that to your expenses. That would mean your costs, now $12,485, exceed that of your income! Not only do you negate any tax owed, but you also show a slight paper loss of $485 for the year, even though you brought in $3,000 excess cash from your rental income.

That’s the power of real estate depreciation!

What Properties Are Eligible for Real Estate Depreciation?

Not all aspects of real estate are depreciable. Indeed, they have particular requirements for depreciation, including:

  • You must own the property
  • You must be using the property to produce income
  • The property itself must have a determinable useful life (residential real estate is automatically 27.5 years and commercial is 40).
  • You must not acquire and dispose of the property in the same year.
  • Some property types are not depreciable. For example, the land is not depreciable, although real estate structures are.

Real estate owners can deduct depreciation up until the entire cost basis is up (so, in our example above with a 100,000 single-family home, once the depreciation deductions reach $100,000, no further depreciation is permissible. If owners retire the asset early, depreciation deductions end once that asset is no longer producing income.

Lastly, you can deduct depreciation for properties that are temporarily not producing revenue – such as when a tenant leaves, and you’re searching for a new tenant. However, you must make at least one repair to qualify.

How Do Investors Calculate These Deduction Amounts?

Unfortunately, like most things tax-related, calculating these amounts is convoluted. Assuming you put your asset into use after 1986, you’ll use the Modified Accelerated Cost Recovery System (MACRS). This system amortizes costs and deducts depreciation over the useful life of properties as mentioned above residential real estate is automatically 27.5 years and commercial is 39 years. If you put your property into service before 1986, you should be using the original Accelerated Cost Recovery System (ACRS).

The full details of these amounts are in IRS publication 946. In particular, for residential rental properties, you will want to refer to Table A-6, which describes how much you can deduct each year based on what month you put your property in service. For non-residential real property on the 39-year amortization schedule, you’ll want Table A-7a.

Since real estate depreciation is complex, please consult with a qualified tax accountant to ensure you correctly make the calculations. Even though it may cost some money, it’s worth it to know you’re claiming this depreciation correctly and to the maximum amount possible!

Real Estate Depreciation Helps Offset Investment Losses

Depreciation helps real estate investors in a multitude of ways.  For starters, it helps spread out the cost of a property over multiple years, helping to offset years with investment losses. Even as a passive real estate investor  – you have the ability to take advantage of the tax advantages of real estate deprecation. Indeed, depreciation alone won’t make you rich, but it will help reduce your tax liability, which is always beneficial. It’s also one decisive advantage that real estate has that other investments do not – you cannot depreciate the value of a stock or bond to reduce your overall tax liability!