Depreciation – Save Now and Pay Later?

Its tax time! Yet again this year, we reaped the here and now tax benefits of rental property investing. Foremost of which is the deduction of expenses from gross rental income which greatly reduces the taxable income from the rentals.  

I’ve blogged previously about the tax advantages of real estate and my personal favorite deduction from rental income, depreciation. This week, I wanted to share an excerpt from my upcoming book, “Collect Rent, Don’t Pay It: A Beginner’s Guide to Rental Property Investing” where I do my best to explain the good and bad of rental property depreciation in layman’s terms! 

My favorite deduction from rental income is depreciation! Depreciation is simply reducing the value of a certain property over its useful life. Real estate, the structure only, can be depreciated over its useful life, a maximum of 27.5 years as currently determined by the IRS. Rental property can be depreciated all the way down to zero.

The most common means for determining depreciation is the straight-line method but again use an accountant or tax software to determine exact depreciation for each tax year. To determine depreciation, one must know the cost basis for the property. Basis is what it costs to take ownership and place the property into operation.

Basis for the property can include many of the required fees to purchase the property as well as repairs required to get it rent ready. Let’s say an investor bought a property for a purchase price of $140000 but with closing costs and some repairs, the final cost to get renters in the door was $150000. $150000 can be used as the cost basis as long as everything is documented. This will be the starting point for calculating annual depreciation over the next 27.5 years.

Using this example and the straight line method, this property could be depreciated $5455 each year owned! The depreciation would be deducted from gross rental income for the property along with all the other expenses, greatly reducing taxable income or perhaps even creating an on paper loss.

Depreciation is the best tax benefit of owning investment property but it does come with a catch. When selling an investment property, the investor will have to pay capital gains tax and depreciation recapture.  Yet another reason, perhaps the primary reason, real estate is a long term investment!

First a look at capital gains. Let’s say the seller held that property with a basis of $150000 for 10 years and sold it for a net of $200000 (after all seller costs and commissions are paid). There will be capital gains tax on the $50,000 profit. Capital gains tax are generally 15% but can run up to 20% depending on the gain. In this example, 15% would be a $7,500 capital gains tax bill.

Depreciation recapture is a little more complicated. Recapture is the IRS collecting income tax on the income offset (depreciation deduction) they gave you all those years.  Depreciation recapture is taxed at the filer’s personal income tax bracket up to 25%.

Sticking with the numbers we’ve used so far and assuming the investor is in the 22% tax bracket, after selling a property depreciated for 10 years, the investor will have to pay $12000 in depreciation recapture tax. This means there is the potential for a total of $19500 in taxes when disposing of the property. 

So isn’t the tax break associated with rental property investing really a question of pay now or pay later? Perhaps, but I am a firm believer in the time value of money which in simplest terms means $1000 invested today is worth a whole lot more in 20 years than if one were to just hang on to it and wait 20 years before investing.

Rental properties are a long term investment. I used a 10 year example to show capital gains and depreciation recapture but what if the asset was held 15 years, 20 years or even longer? Each year the investor would receive that $5455 depreciation offset from rental income on their personal taxes.

The growth of 10-20 years’ worth of tax advantaged income from real estate that is wisely reinvested should more than cover any tax burden when the property is eventually sold.

Also, there are a few tax advantaged means to dispose of a real estate investment. A 1031 exchange rolls the proceeds from the sale of a property towards the purchase of a like kind investment thus avoiding (or perhaps more accurately, delaying) capital gains and depreciation recapture tax.

How could this play out? Say you are getting to the stage in life where managing that duplex is too much hassle. Sell the duplex in a 1031 exchange and use the proceeds to buy a beachfront condo! As long as the primary purpose of the condo is as a rental, there will be no capital gains tax. The owner can still have some personal use of the condo, up to a point…check with a professional.

Currently, passing on to heirs an investment property as part of an estate will also mitigate the tax burden if the heirs choose to sell the property. Simply put, heirs do not inherit the depreciation. Currently, there is increasing discussion in the political arena about doing away with this benefit.

In addition to rental income and growing equity, the tax advantages of rental property in the here and now is yet another source of profit for the investor. Check out “Collect Rent, Don’t Pay It!” coming soon on Amazon! Join me next week for a look at “setting the conditions” to begin investing in rentals.

Want to learn more about the financial truths that have helped our average American family achieve success? Check out my book, Millionaire on a Worker’s Budget: Five Financial Truths to Build Wealth on sale now at Amazon!

The commentary provided in this blog is for informational purposes only and is not intended to be a source of financial or investing advice.

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