How to Maximize Your Real Estate Depreciation

How to Maximize Your Real Estate Depreciation

As this year’s tax filing season approaches, I’m aware that many real estate investors have an incomplete understanding about depreciation on rental investments. The majority of investors believe that rental properties must be depreciated over 27.5 years. I think the reason for this is because that’s the default number used by the majority of tax accountants. While this is fine and legal by IRS standards, you can choose a different method that is also approved by the IRS and maximize your depreciation.

The Choice is Yours

Many real estate investors don’t realize that you can independently decide if and how you depreciate your rental property. Obviously, there are certain guidelines set in place by the IRS. But the choice is ultimately yours. Bear in mind that your tax accountant may not be savvy as far as real estate investments. It’s always worth it to find a tax professional with specific experience with real estate matters.

Now before I go any further, you should know that I am not a CPA or a tax attorney. I served as a professional actuary for 15 years, but I’m sharing the information in this article from an experienced real estate investor perspective. Please conduct your due diligence before applying any of the ideas discussed in this article. Speak to your accountant and tax specialist to make sure that the method you choose is beneficial to your personal circumstances, as every situation is different. There are many approved depreciation methods, but for the purposes of this article, I’ll be focusing on the component depreciation method.

The Tax Reform of 2018

The tax reform of 2018 ushered in some significant changes to the Tax Code by allowing any building component with a tax recovery period of 20 years or less to be eligible for 100% bonus depreciation. Historically, bonus depreciation only applied to new construction, but since 2018 it applies to any acquired property. Let me give you an example to illustrate the impact of the new tax law could affect your personal taxes.

Let’s say you acquired a 20-unit apartment building for $1 million. Since the depreciation only applies to the building itself (aka improvement) we must discount the value of the land. Let’s say the land is worth 20% of the total value. We then depreciate only the value of the building, which is $800,000. Your accountant depreciated the building over 27.5 years as the default, which comes out to about $30k per year.

The reason for this article is to show you another depreciation method called component depreciation. This method breaks down the building into its components and then depreciates each component according to the IRS depreciation schedule as shown below:

When you bought the same 20-unit apartment building in the example above, you bought walls, roofs, stoves, fridges, washing machines, dryers, HVAC, carpet, fence, sidewalk, parking lot, pavement, etc. You can break down the value as follows:

If you’re wondering where I got these numbers, you should know that you cannot do this breakdown yourself. This requires a cost segregation study completed by a certified member of American Society of Cost Segregation Professionals (ASCSP). I personally use a particular cost segregation firm for all my cost segregation studies and I‘d be happy to share their name and contact information with you upon request. You can also contact a cost segregation firm to help give you an idea of how the cost segregation study might help you. The cost segregation study would basically come up with the value for each of these classes.

The annual depreciation above assumes that each asset class is depreciated on their useful life which comes to $43k (80/5 + 40/15+ 680/27.5). But as I mentioned earlier, the tax reform of 2018 lets you depreciate 100% of any asset with a recovery period of 20 years or less. That means that your first year depreciation would be $144k ($80k * 100% + $40K * 100% + $680k/27.5). This represents a massive increase for the first year’s depreciation, while the annual depreciation would go down to $24,727k in the following years.

You can see the stark difference between the two methods of depreciation in the comparison table below:

How Does This Alternative Depreciation Method Affect My Tax Liability?

How this depreciation affects your tax bottom line depends on your tax filing classification as well as the differentiation between passive income and ordinary income. In most cases, the IRS wants losses from passive income to offset passive gains; not ordinary income. In other words, your passive income loss cannot offset ordinary income. As usual, there are exceptions to these rules. Much depends on how you make a living or what is the meaning of ordinary income and passive income to you personally. A critical component on how much passive income loss can offset your ordinary income is how the IRS categorizes you as a real estate investor.

The IRS Categories of Real Estate Investor

The IRS uses four categories of real estate investor and they affect how much passive income loss you can leverage. Let me discuss the two categories that are most relevant to this discussion, Real Estate Investor and Real Estate Professional.

Real Estate Investor is the category most taxpayers who invest in real estate fall under. These individuals typically have a full-time job. They purchase investment property with the intent of holding it and producing a gain. Income and losses for these taxpayers are considered passive . As such, that passive income cannot be used to offset ordinary income from their employment. There is one exception (as usual). If the investor’s Modified Adjusted Gross Income is less than $100k then they can offset their ordinary income up to $25k with their passive income loss.

As an example, let’s say I’m a doctor making $200k a year and I purchase the 20-unit apartment building we discussed above. Let’s say that the building generates $44k of net passive income for the year before depreciation. Once we take the depreciation out we end up with a loss of $100k from passive income. Because my Adjusted Gross Income is higher than $100K I cannot use this loss to offset my ordinary income. In this example, the doctor might be better off not doing the cost segregation study and applying the straight line depreciation.

Another real estate investor category is the Real Estate Professional. To qualify as a Real Estate Professional, you must spend at least 750 hours each year in the real estate business. Since there are only so many hours in the day, if you have a full-time job you most likely won’t qualify. Real Estate Professionals can deduct 100% of passive income losses from ordinary income. If I’m a Real Estate Professional making $200k per year I can deduct $100k passive income loss from my regular $200K ordinary W2 income, etc. This is huge. Check with your CPA if you could qualify as a Real Estate Professional and take advantage of this incredible benefit.

I Bought The Building Last Year. Is It Too Late To Benefit?

You may still be able to benefit. If you bought your building in 2018 you could do the cost segregation study and get the benefit by having a tax professional amend your 2018 income tax filing. If you bought the property prior to that, a cost segregation firm can do a look-back study. You could take advantage by applying a catch-up depreciation for your 2019 income tax filing. The cost segregation firm are the experts and they can help you through that process. Almost all of these firms also provide audit support in case the IRS ever needs clarification.

The Benefits of ComponentAccelerated Depreciation

Depreciation is typically something that most real estate investors leave up to their CPA. As you can see, there are tremendous tax benefits to using the component depreciation method, whether you’re a Real Estate Investor or a Real Estate Professional. Standard depreciation may be right for your individual circumstances. However, with the Tax Reform of 2018, you deserve to know how your tax liability could be favorably offset by using an accelerated depreciation method on acquired property components. I recommend that you consult with your tax professional at this time to discuss your options.