Real Estate (Tax) Depreciation

One of the biggest reasons people love investing in income-producing real estate is because of the tax benefits. In particular, depreciation makes it so we can generate cash flow, that we don’t necessarily have to pay tax on!

I’m Gabriel Velez, partner at Tehrani & Velez, LLP, and we’re a tax accounting firm based out of Irvine, California. In this article, I’m going to explain what tax depreciation is, how it fits into your overall investing tax strategy, and describe some differences between residential and nonresidential real estate tax treatment.

What is Depreciation?

So what exactly is depreciation? In the context of tax and accounting, it’s not the opposite appreciation, which has to do with the fair market value of an asset. No, depreciation is a cost allocation and recovery system. Rather than writing off the full price of an asset the day you buy it, you typically have to spread that cost over several years, the time period approximating it’s “useful life”.

Because of the subjectiveness and uncertainty with trying to figure out an asset’s “useful life,” the IRS created a system for taxpayers to follow called the Modified Accelerated Cost Recovery System (or MACRS, pronounced “makers”, for short).  

One quick comment on depreciation: an asset must be placed-in-service to qualify for depreciation. That means a property used personally won’t qualify, nor will property you’re planning to fix and flip. For real estate, placed-in-service means you’re using the property to generate income in a trade or business, or you're making a property available for rent (so long as your intention is to actually rent that property).

Modified Accelerated Cost Recovery System (MACRS)

The next thing I’m going to do is expand on how the MACRS system works. The main areas of concern are (1) the METHOD by which we’re depreciating an asset and (2) the RECOVERY PERIOD. The recovery period is the number of years you get to spread your cost over, so the fewer years, the more depreciation you get to take each year. The method of depreciation is how you allocate that cost over the recovery period. Straight-line depreciation, for instance, takes the same amount depreciation every year, whereas the 200-percent declining basis method takes more depreciation in early years and less in later years.  

I’ll give you some concrete examples by running down a few common asset categories:

• The first thing to note is LAND does not depreciate. When you buy real estate, you’re always going to have to allocate the purchase price between the land and the dwelling. Whatever cost is allocated to the dwelling is what you use for depreciation, the cost allocated to land just sits there until you dispose of your property.
• NONRESIDENTIAL REAL ESTATE, which we’ll describe in more detail in part 3, depreciates using the straight-line method, over 39 years.  
• RESIDENTIAL REAL ESTATE, which I’ll be going through in part 2, depreciates on straight-line, over 27.5 years.  
• Next, are LAND IMPROVEMENTS, that include fences, landscaping (that’s not on the perimeter of the property), driveways, parking lots, etcetera. 15-year, straight-line depreciation. 
• On the slide, you’ll notice a thick grey dotted line. This line separates Real Property from Personal Property (sometimes referred to as Realty and Personalty, respectively). This distinction is important, as we’ll see later on, Realty and Personalty have a lot of differing tax rules.
• PERSONAL PROPERTY depreciates under a 200% declining balance method and we typically call the asset class by its recovery period.
• Examples of 7-year property are Office Furniture, Fixtures, and General Equipment
• Examples of 5-year property are Computers, High-Speed Printers, POS systems...actually a lot can be considered 5-year property.

Note: What I just described is the General Depreciation System under MACRS (GDS), there is also an Alternative Depreciation System (ADS), however the GDS is used more frequently than ADS, and it’s just impossible to go through everything in one short article, I haven’t even touched on the Alternative Minimum Tax (AMT) system!

Asset vs. Expense

In general, you want to be able to deduct your costs as soon as possible to take advantage of the tax benefits. This increases your short-term cash flow, so you can go out and invest more. Of course, there are many factors to consider, like if you used to debt to finance the purchase of an asset, you’ll have to address that negative cash flow eventually, either by refinancing or biting the bullet. Also, our current tax laws are extremely favorable, historically speaking, so you might want to lock in your tax rate now, rather than wait...but I digress. More deductions now are generally better, that’s why it’s good to understand the difference between an asset that you have depreciation, and an expense you get to deduct on day one.

An improvement to your property is classified as an asset and falls under the MACRS’s rules for deductions. Conversely, items classified as Repairs and Maintenance are deductible in the year incurred, irrespective of any of the aforementioned rules. Some examples of repairs and maintenance:

• Roofs (as long as it’s just the shingles/membrane and not the decking, decking is an improvement)
• Painting
• Termite inspection/service (spraying, not new wood)

You also have De Minimis rules, where something might technically be an asset, but you get to expense it anyway because the cost is negligible given the circumstances.

• De Minimis is anything less than $2,500 per invoice OR per item that is shown on the invoice. In order to qualify, the De Minimis rules must be elected on the tax return and,
• you need an accounting policy, written or unwritten. This typically means book conformity.
• You may also qualify for up to a $5,000 De Minimis threshold if you have an Audited Financial Statement.

Another strategy for accelerating how quickly you can recover your cost/investment is termed “cost segregation.” “Cost Segregation” is a marketing term for breaking a property, or a set of improvements, down into smaller assets in the attempt to us the more advantageous depreciation rates like those applicable to land improvements and personal property.

Residential Real Estate

In the world of taxation, residential real estate is ANY real property whose intended use is as a dwelling by an individual or family. This definition differs from the real estate industry’s definition where “residential” typically means a dwelling with no more than 4 units, which excludes apartment buildings. By default, this type of asset has a depreciable life of 27.5 years.

Cost Allocation

The first thing we have to do when we buy a rental property is to determine the correct cost allocation. That means breaking down the settlement statement (which used to be called the HUD-1) and the disclosure statement by correctly allocating things like prorated property tax, prorated HOA dues, escrow fees, title charges, and new loan points and fees. Part of these charges are expenses for the year in which they’re paid, but most of them usually become part of the properties cost basis.

Next, we allocate the cost between land and dwelling while keeping in mind, land does not depreciate. We can allocate cost using a variety of different reasonable methods, but the most common is taking the county assessor's office appraisal (this typically isn’t the most accurate or beneficial, but it is readily available) or by using another qualified appraisal. Remember, Residential Real Estate depreciates using the straight-line method over 27.5 years. 

Personal Property (Used in a Trade or Business/Rental Activity)

Once your property is up-and-running, you may from time-to-time have to furnish it or replace its appliances. For the most part, anything that isn’t structural or attached to the property is considered personal property. That includes carpeting, drapes, furniture, and appliances.  

The great thing about personal property is that it qualifies for Section 179 and bonus depreciation. Both Section 179 and bonus depreciation (after 2017) is a form of accelerated depreciation. How fast is the depreciation you ask? You get to deduct the entire purchase price in the year that asset is placed-in-service. Section 179 is subject to income and investment limitations, that I won’t be going into today. Bonus depreciation has no such limitation and in a post-2017, tax cuts and jobs act has very few limitations altogether. Under current tax laws, bonus depreciation will begin to phase-out between 2023 and 2026, but that’ll have no bearing on assets you place in-service from now until then.

Capital Gain and Depreciation Recapture

Something that you need to be aware of, if you ever go to sell a property is depreciation recapture. Depreciation recapture works like this: say you bought a property for $500,000, and over the period you held that property you took a depreciation deduction of $100,000. Well, you’d have an adjusted basis in that property of $400,000 ($500k less $100k). Then you go to sell that property for $750,000 and that would give you a taxable gain of $350,000 ($750k minus $400k). Of that $350,000, $100,000 would be depreciation recapture and subject to special tax rates depending on the type of property and depreciation you took. The other $250,000 would be treated as Capital Gain.

Capital Gains have preferential tax rates. Those rates are 0% for taxpayers in the lowest tax bracket, 20% for taxpayers in the highest tax bracket, and 15% for everyone in between. Keep in mind these rates are marginal, so you may end up with a blended rate.

Unrecaptured Section 1250 gain is the term given to depreciation recapture, on real estate, that is NOT in excess of straight-line depreciation. This type of gain is subject to a flat 25% tax. Depending on your income level, this may or may not be beneficial.

Recaptured Section 1250 gain is for any accelerated depreciation on Real Property. You might have accelerated depreciation if you use a declining balance method of depreciation (not common under current laws) or take advantage of Section 179 or bonus depreciation. This type of gain is subject to your ordinary income tax rate.

Section 1245 gain is for any depreciation recapture on the disposition of Personal Property and is subject to your ordinary income tax bracket.

One way around depreciation recapture, that a lot of real estate investors are familiar with, is called a Section 1031, Like-kind exchange. I’ll talk about that sometime in the future!

Nonresidential Real Estate

In the world of taxation, nonresidential real estate is ANY real property whose intended use is anything other than as a dwelling by an individual or family. This definition differs from the real estate industry’s definition where you typically hear the term “commercial,” instead of “nonresidential;” and where “commercial” real estate includes apartment buildings or anything with more than 4 dwelling units. Nonresidential real estate has a few tax rules that are a lot more aggressive than that of residential real estate. This type of property typically has a depreciable life of 39 years.

Qualified Real Property

One thing that nonresidential real estate has, that residential real estate does not, is this notion of Qualified Real Property (QRP). Property that qualifies for QRP treatment can elect to take Section 179 depreciation. It’s important to note that currently Section 179 is the only accelerated form of depreciation available for this type of property and that QRP has a life of 39 years. That being said, it is expected that Congress will issue a technical correct bringing the life of QRP down to 15 years and opening up the door for bonus depreciation, but we’ve been waiting for this for two years.

Qualified Real Property is any of the following items, when placed-in-service after December 31st, 2017:

• Qualified Improvement Property, which I’ll define shortly
• Nonresidential roofs
• Nonresidential HVACs, and
• Nonresidential fire protection and security/alarm systems

This is huge because if you have the ability to allocate the purchase price on a new property to any of these qualifying items, you’ll get to recover that cost really quick!

Qualified Improvement Property

Qualified Improvement Property (QIP) are any improvements made to the interior of your nonresidential property and that are placed-in-service after the date of purchase. There is no waiting period, so literally, you can begin construction on improvements the day after escrow closes and they qualify.  

Some noteworthy exclusions include enlarging the building, elevators, escalators, and any internal structural framework.

The internal structural framework generally means load-bearing walls. In a lot of office buildings, for instance, there are artificial walls set up to create offices or other divisions. These walls are mostly hollow, not structural in nature, and so walls like that can still qualify as QIP.

Applying What We Learned

In wrapping this whole thing up, I’m going to give you a little insight on how we usually look at using depreciation and the other deductions we talked about in tax planning and preparation.

The first rule we always look at is the De Minimis rule. If we can fit a cost under in this category we’re going to take it. And because the De Minimis threshold is $2,500, most clients are either paying for these items in cash or credit card and want to write them off as soon as possible. Also, because this is categorized as an expense, we don’t have to bother putting it on the asset list and having to look it every year.

Either Bonus Depreciation and Section 179 can go next, but typically, we’ll look at whether a cost qualifies for Section 179 and if the taxpayer will benefit from it. The reason we look at Section 179 next is that the State of California recognizes Section 179 (although with lower deduction limits) it does not recognize Bonus Depreciation.

Finally, we’ll wrap it up with analyzing the usefulness of Bonus Depreciation. Any property with an asset life less than or equal to 20 years qualifies for the bonus. This includes Land Improvements and Personal Property.

Outro

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