A thorough understanding of depreciation is a requirement for effective real estate investment. At first glance, depreciation may seem like an inconvenience—excessively complex and with few benefits for the real estate investor. But that is not entirely the case; the fundamentals of investment property depreciation are not hard to grasp. Here’s an overview of how investors can use depreciation to their advantage.
What Is Investment Property Depreciation?
Depreciation is a mandatory tax deduction that allows a taxpayer to hold back the full cost of an investment in increments over the course of years—between five years for certain personal property used for business purposes and 39 years for nonresidential commercial real estate. Residential commercial real estate, that is, multifamily housing, depreciates over 27.5 years. Thus, if you acquire a multifamily complex, you will deduct 1/27.5 of the tax basis (the price of the complex adjusted for fees and closing costs) every year for that many years. The cost of improvements you make to that property is also deducted at that rate unless it is personal property, which is depreciated over a shorter period of time (discussed below).
Depreciation works very well for some investments. It is ideal for the factory owner who buys new production equipment, for example. It also encourages investors to buy Class C multifamily housing, which loses value due to its limited income-generation horizon. But often real estate gains in value even as it is being depreciated. Unsurprisingly, the government will want some of those deductions back in that case. A process called depreciation recapture is used to return depreciation deductions to the government when you sell your property for a profit. It is also mandatory.
Putting Depreciation to Work for You
While you can’t avoid depreciation, you can sometimes use it to your advantage through accelerated deductions. This means that, under certain circumstances, you can take larger—possibly much larger—depreciation deductions in a year than the typical 1/27.5 of the basis of your property. There are two ways you may be able to do this: though cost segregation or through bonus depreciation. Both of these are tax deferrals, since they affect the time when you pay your taxes, not the amount of taxes you pay.
Cost segregation identifies elements in your investment property that can be reclassified as personal property. A highly trained specialist performs a cost segregation study to identify individual elements inside apartments that are used to encourage the rental of the units, rather than for the operation of the building, and reclassifies those items as personal. Those elements are singled out using highly technical criteria, although, to make a sweeping generalization, they are often things that are replaceable. This reclassification gives those elements a much shorter depreciation time, likely between five and 15 years, allowing you to deduct a greater portion of their value every year. Not only that, the findings of your cost segregation report can be applied retroactively to 1986, if you owned the property for that long.
Currently, bonus depreciation temporarily gives you the option of deducting the full cost of newly acquired large equipment, such as HVAC or other infrastructural systems, for properties acquired and in service after September 27,2017 if certain qualifications outlined by the IRS are met. Personal items with a depreciation period of 20 years or less—the type of items found in cost segregation—are also eligible for bonus depreciation. You have to be careful only to deduct eligible equipment, however. Improvements to the land are subject to standard depreciation, but not bonus depreciation. It is best to consult an expert who can distinguish them.
Avoiding Depreciation Recapture
Depreciation recapture is paid along with capital gains taxes when an asset is sold. If you take bonus depreciation and then sell the depreciated asset too quickly, you will pay more depreciation recapture than you would have otherwise. However, like capital gains taxes, depreciation recapture can be deferred in a 1031 exchange. As long as you continue to exchange, your depreciation recapture will roll over into the next property you purchase and only come due when you sell. If you never sell the asset and it passes to your heirs instead, the tax will be “stepped up” to the estate tax on the asset at its market value.
You cannot conduct a 1031 exchange on your own. You’ll need a qualified intermediary to ensure that you do not take receipt of funds from the sale of the asset you are exchanging, and you’ll likely need professional advice to guide you through the complex exchange process.
Depreciation is not a difficult concept to grasp, but it requires a firm understanding of its details to make it work in your favor. Professional advice can help you take advantage of depreciation to use your investment money more efficiently.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and multifamily real estate valuation to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country and employ a team of experts who can help you hone your investment strategy.
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