What exactly is depreciation, though?
Buildings and other types of property suffer wear and tear over time, making them less useful and contributing to a subsequent decrease in value. Depreciation is one of the most beneficial annual tax deductions for rental properties, and property owners and investors can use it to offset the cost of maintaining and managing their rental properties.
On the other hand, in contrast to the interest you pay on a loan for the property or any other operating expenses related to it, you are not allowed to deduct the purchase of rental property in the same year that you buy it. Instead, you will have to spread out your deductions for the cost of the property over a longer period of time because the value of real estate generally increases over time.
Because of this long lifespan, depreciation is quite valuable because you get it year after year (for 27.5 years when it comes to residential real property), and you don’t have to pay anything more than your initial investment in the property to receive it. In other words, you don’t have to give up anything in exchange for it. In addition, it’s highly possible that the value of your property will rise over the course of time, despite the fact that you’ll still be entitled to depreciation.
When discussing the benefits of investing in real estate, people frequently bring up the tax advantages. In particular, depreciation, which is known as a “cashless expense,” frequently makes it possible for a property to report a loss for tax purposes while nevertheless maintaining a positive cash flow. But the IRS will take away from you just as much as they give you. When you sell a property, the Internal Revenue Service will employ a method called depreciation recapture to take some of the tax advantages you’ve earned via depreciation and give them to themselves.
An Analysis of Real Estate’s Depreciation
When they occur, the IRS permits firms to deduct a significant portion of their typical and essential expenditures. That is to say, these expenditures bring about a reduction in the present taxable income. This treatment of the current deduction is consistent with the accounting principle of allocating expenses to the periods in which those expenses contribute to the generation of income.
Instead, the Internal Revenue Service applies a method of accounting known as depreciation to these larger purchases. Investors in real estate typically spread out their write-offs of property purchases across a number of years, rather than taking the full cost of the investment as a deduction in the year of acquisition. In this fashion, you match a portion of the acquisition cost to multiple years of income.
There are many different depreciation methods, but the most popular for real estate is referred to as straight-line depreciation. These straight-line durations are prescribed by the Modified Accelerated Cost Recovery System (MACRS) of the IRS. Owners depreciate their property over a 27.5-year period for residential real estate. The depreciation term for commercial property is 39 years.
Let’s use the purchase of a $500,000 rental property as an example. Assuming you made no capital improvements following the purchase, that $500,000 becomes your taxable basis. And, if $400,000 of that purchase price is allocated to the property improvements (i.e. the home), that becomes your depreciable basis (remember, you cannot depreciate acquisition cost allocable to land) (remember, you cannot depreciate acquisition cost allocable to land). As a residential property, you divide this depreciable basis by 27.5 to determine an annual depreciation expense of $14,545 ($400,000 depreciable basis divided by 27.5 years).
In other words, every year you possess that rental property, you can cut your taxable income by $14,545, despite not really having an accompanying cash spend of $14,545.
 Depreciation
Despite the incredible tax benefits that depreciation provides, the Internal Revenue Service will take back a portion of those benefits if and when you sell a rental property in the future. The Internal Revenue Service (IRS) levies a one-time tax equal to 25% of a property’s total eligible straight-line depreciation over the course of the ownership period. This method is known as “depreciation recapture.” When you sell a property, the Internal Revenue Service (IRS) will still charge you the depreciation recapture tax even if you don’t claim any depreciation on your taxes.
Recapture
Your taxes will still go down thanks to depreciation, but if the value of your property goes up, the Internal Revenue Service will try to “recapture” the taxes you are now avoiding paying.
When you sell the property, the IRS receives the taxes that they are owed, as a result. They levy a tax on the portion of your sales profit that is attributable to the deductions for depreciation. This practice is referred to as “depreciation recapture” for rental properties. You will pay a higher tax when you sell your property in the future as a result of recapture, but it will work out well for you in the near future because it will give you more access to capital. However, it will ensure that you pay that tax.
Because of recapture, deductions taken in the same year as their occurrence are typically more lucrative than depreciated deductions.
Final Thoughts
There are, to one’s great relief, methods available to postpone or, in some instances, completely avoid depreciation recapture taxes. It is absolutely necessary for first-time real estate investors to have at least a fundamental familiarity. If you don’t have this foundation, you won’t be able to take advantage of the benefits that these tax-planning tactics present.
To get the most out of your tax return, it is essential to have a fundamental understanding of rental property depreciation recapture. If you are familiar with the intricacies of depreciation, you will be able to cut costs and maximize the benefits of tax deductions.
There is further information that we have not covered in this article; thus, if you have an unusual tax position, you should do some additional study and consult with a qualified accountant.
