Depreciation

Depreciation is a loss in the value of an asset. The Federal tax code allows you to take a deduction for depreciation on assets used for business purposes (like real estate investment property) each year to offset your investment income and/or ordinary income. Depreciation can be taken for buildings, machinery, appliances, furniture, fixtures, cars, computers, anything with a useful life span of over 1 year, that does not last indefinitely, and is used for business.

Everything ages over time from wear and tear and frequent use, there is a corresponding drop in an asset value the more it used. Eventually the asset wears out and reaches the end of its useful life and needs to be replaced. Depreciation allows the owner to deduct a portion of the asset’s value each year as a loss to account for its deterioration from use. Investors love depreciation because it provides hefty tax deductions which increases the investment property’s after tax cash flow, or provides a tax shelter for the owner’s personal income.

Depreciation increases cash flow

Almost always, the depreciation schedule will be shorter than the actual useful life of an asset. Residential Real Estate has a 27.5 year depreciation schedule, however we know that with regular upkeep residential houses can last for 100’s of years. Depreciation is like taking a ‘phantom loss’- because at the end of 27.5 years the building will be worthless in the IRS eyes (basis reduced to zero) but when you sell the property for a gain, depreciation recaptured (see below) is taxed to account for the difference in book value ($o) and sale value (anything). Depreciation lowers your property’s tax basis.

I recommend talking with an accountant about Depreciation. Need a Los Angeles real estate accountant referral? Let me know and I am happy to provide one.

For more Depreciation information, See IRS Publication 946.

How Depreciation Works

Land cannot be depreciated.

Land depreciation

Land is indestructible and never gets used up so it is exempt. You must separate the cost of the land from building, since only the building portion of the property is depreciable.

Trailer mobile home

If you bought a condo, that is easy, since the purchase price did not include any land. But for Houses, Apartment Buildings, and other investment properties that have structures and land you will have to subtract the value of the land from the basis.

Many owners, have no idea how much their land is worth. They know what they paid for the property but the purchase contract did not specify how much of the purchase price was for the house and how much was for the land. As an investor, you want as little land value and maximum structure value as possible because this will maximize the amount of depreciation you can take, so when you are estimating the ratio of land value to structure value, I would be on the liberal side with estimating structure value.

scales land building

The More Structure the better for Depreciation

If you are not certain of the values, you could just guess what you think each is worth? How an accountant would figure it out, is they would look at the properties assessed value on the tax rolls, and take the ratio of Structure to Assessed Value and apply it to the purchase price.

Example

1265 S termaine

1265 S Tremaine Ave

1265 S Tremaine Ave is a duplex that is listed for sale for $990,000. How much of the value is land vs structure?

1265 tremaine property profile

Assessor Information

The Assessor shows that the current tax roll values are $249,622 for Land and $137,289 for improvements. I would go to the city and talk with them about this because it should be flipped. I expect structure at least to be 60% to 80% of value. But lets continue with this example. $249,622 Land + $137,289 Improvements = $386,911 Total Assessed Value. Take the Improvement divided by Total value to get the ratio. $137,622 Structure/$386,911 assessed value = 35.5% building to land ratio. Take the new purchase price $990,000 * .355 =  $352,137 value of Structure. Again, I would go to the city because this seems very low.

 Depreciation Method – MACRS – GDS

Modified Accelerated Cost Recovery System (MACRS) is the standard method used for depreciation of investment real estate put into service after 1986. There are two different systems for MACRS, the General Depreciation System (GDS) and Alternative Depreciation System (ADS). You will be be using GDS for investment property you own in the US. The Depreciation recovery periods are longer for ADS which is why you don’t want to use it. The recovery period for residential real estate under ADS is 40 years! as oppose to 27.5 years with GDS.

straight line

Real Estate Depreciation is calculated with the straight line method

All Real Estate depreciation must be calculated by the Straight Line Method (it is very easy). Personal Property has 150% and 200% declining Balance options for depreciation methods.

straight line depreciation equation

Straightline Depreciation Equation

made up graph

Made up Graph of straight line depreciation, you deduct the same amount each year until there is zero basis.

I like this online depreciation calculator: http://www.calculatorsoup.com/calculators/financial/depreciation-property-realestate.php

GDS assigns Recovery periods for different assets:

MACRS GDS property classes

Property Class Personal Property (all property except real-estate)
3-year property Tractors
Race Horses
Special handling devices for food and beverage manufacture
Special tools for the manufacture of finished plastic products, fabricated metal products, and motor vehicles
5-year property Automobiles, taxis, buses, trucks.
Computers
Office Machinery
Cattle
Appliances, carpets, furniture (residential real estate use)
Airplanes
Petroleum drilling equipment
Certain geothermal, solar, and wind energy properties.
7-year property Office furniture, fixtures, and equipment (such as desks, files, and safes)
Manufacturing Machinery and equipment (agriculture, mining, weaving, tobacco etc)
10-year property Boats, Barges, Tugs, and water transportation Equipment
Trees and vines that bear fruit
15-year property Improvements to Land (landscaping, fences, roads, sidewalks, bridges)
Cement
Wharves and Docks
Restaurants
Gas Stations
Telephone Communications
Municipal sewage treatment plants
Oil and Gas Pipelines
Nuclear Power plant
20-year property Farm Buildings
Railroad Structures
Utility Service (Electric, Water, Gas)
Municipal sewers
Property Class Real Property (real estate)
27.5-year property Residential rental property (does not include hotels and motels)
39-year property Non-residential real property

This Article, is focused on Real Estate Depreciation, so I wont be going into how depreciating personal property works but its different. The most common personal property you run into is the Automobile that can be depreciated over 5 years. The MACRS system does not use Salvage value, although older depreciation systems used by the IRS did- but if you are wondering the salvage value for real estate is zero.

Residential Real Estate has a shorter Depreciation timeline than Commercial Property.

Residential Property Commercial Property
27.5 Years 39 Years

Example Residential: You purchased a $500,000 Duplex in 2009, that had land value of $200,000 and a structure value of $300,000- how much depreciation can you deduct?

$300,000 structure value/ 27.5 years = $10,909 depreciation per year.

Example Commercial: You purchased a $500,000 5 Unit apartment building in 2009, that has a land value of $200,000 and a structure value of $300,000- how much depreciation can you deduct?

$300,000 structure value/ 39 years = $7,692 deprecition per year

 How Does Improvements to Property Work for Deprecation?

Let’s suppose that in the example above with the duplex after five years of owning it- in 2014, you decided to build a 3rd unit on the property over the garage. The unit cost you $150,000 to build. Can you Depreciate it? Of course! Additions and New Construction is treated as Real Property and has either a 27.5 year schedule for residential and 39 year schedule for commercial. In 2014 when you build the extra unit the $150,000 of construction cost gets added to your basis. Here is a table of the deduction schedule:

Year Book Value Depreciation Accumulated Deprecation Book Value End
2009 $300,000 $10,454 $10,457 $289,546
2010 $289,546 $10,909 $21,366 $278,637
2011 $278,637 $10,909 $32,275 $267,728
2012 $267,728 $10,909 $43,184 $256,819
2013 $256,819 $10,909 $54,093 $245,910
2014 (150K improvement) $395,910 $16,136 $70,244 $379,774
2015 $379,774 $16,363 $86,607 $363,411
2016 $363,411 $16,363 $102,970 $347,048
2017 $347,048 $16,363 $119,333 $330,685
2018 $330,685 $16,363 $135,696 $314,322
2019 $314,322 $16,363 $152,059 $297,959
2020 $297,959 $16,363 $168,422 $281,596
2021 $281,596 $16,363 $184,785 $265,233
2022 $265,233 $16,363 $201,148 $248,870
2023 $248,870 $16,363 $217,511 $232,507
2024 $232,507 $16,363 $233,874 $216,144
2025 $216,144 $16,363 $250,237 $199,781
2026 $199,781 $16,363 $266,600 $183,418
2027 $183,418 $16,363 $282,963 $167,055
2028 $167,055 $16,363 $299,326 $150,692
2029 $150,692 $16,363 $315,689 $134,329
2030 $134,329 $16,363 $332,052 $117,966
2031 $117,966 $16,363 $348,415 $101,603
2032 $101,603 $16,363 $364,778 $85,240
2033 $85,240 $16,363 $381,141 $68,877
2034 $68,877 $16,363 $397,504 $52,514
2035 $52,514 $16,363 $413,867 $36,151
2036 (original structure fully deducted) $36,151 $11,363 $425,230 $24,785
2037 $24,785 $5,454 $430,684 $19,331
2038 $19,331 $5,454 $436,138 $13,877
2039 $13,877 $5,454 $441,592 $8,423
2040 $8,423 $5,454 $447,046 $2,969
2041 $2,969 $2,954 $450,000 0

 Depreciation Recapture

If you claim depreciation on real estate, that property is considered 1250 property for federal tax purposes. When you sell 1250 property- if the property has a gain over its adjusted basis, the proceeds go in two separate buckets, you must pay Depreciation Recapture tax for the first bucket- and any gain beyond depreciation recapture is a capital gain and subject to capital gains tax and goes in the capital gains tax bucket, unless you defer both taxes with a 1031 Exchange.

The government allows you to reduce the asset value to zero with depreciation, but if you sell the property for more than its basis, this tells the government that it in fact, the building is not worthless, and they want to collect the “back taxes” on the ordinary income you offset over the years Depreciating with Depreciation Recapture.

The Tax rate for Depreciation recapture is 25%, which is slightly higher than the maximum capital gains tax currently of 20%, but probably still a lot lower than what you would have paid in ordinary income tax.

Let’s say an investor bought a rental property a few years ago for $100,000 and took $20,000 in depreciation.

Example 1. Loss

Assume the property sells for $70,000. The Adjusted basis in the property is $80,000 so this sale results in a loss and no tax is due. Depreciation Capture doesn’t carry over to a new property or follow the tax payer. The depreciation capture tax liability is lifted once you sell the property.

Example 2. Just Enough Gain for Deprection to be recaptured

Assume the property sells for $100,000. This is the same price as you bought it for several years ago, except now, the government views this sale as a gain of $20,000! You have to pay Depreciation recapture tax on the gain which is 25% or $5,000

Example 3. Gain large enough for depreciation capture + Capital gain

Assume the property sells for $150,000. Now you have $70,000 gain over your adjusted basis. $20,000 of the gain will be taxed at Depreciation Recapture rate of 25% ($5,000), and the remaining $50,000 gain will be taxed at Long Term Capital Gains tax rate, for this example lets say 20% ($10,000).

California State Depreciation Taxes

California doesn’t have any special tax rates for Capital Gains tax or Depreciation Recapture. On your California tax return, Depreciation Recapture and Capital gains are taxed like any other income at your state rate.

For very Large Commercial Properties, a Cost Segregation (“cost seg”)analysis may grant higher annual depreciation deductions.

 

 

 

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