Depreciation and Accelerated Depreciation Allow Real Estate Investors to Take Significant Tax Deductions
Investing in multifamily and commercial real estate has a variety of incredible tax benefits-- and the ability to take depreciation deductions is one of them. Physical items, including real estate, degrade and become less valuable over time, so the IRS allows investors to deduct the cost of that degradation from their overall income on an annual basis, reducing their overall tax burden.
There are multiple types of depreciation; the major types relevant to commercial real estate investors include straight-line depreciation, accelerated depreciation, and bonus depreciation.
Straight-line depreciation is the simplest type of depreciation and is typically utilized by taking an equal tax deduction each year until the building is fully depreciated. Accelerated depreciation allows investors to take their depreciation deductions on a faster, or “accelerated” schedule, typically by ordering a cost segregation study. Bonus depreciation is a specialized type of depreciation that allows investors to take an even larger deduction over a 1-year period, sometimes up to 100% of the improved value of the property.
Straight-Line Depreciation Allows Real Estate Investors to Take Long-Term Depreciation Deductions
As previously mentioned, straight-line depreciation is the most simple form of depreciation. Non-multifamily commercial real estate can be depreciated over 39 years, while multifamily real estate can be depreciated over a 27.5-year period.
When it comes to taking depreciation deductions, the value of the land cannot be incorporated into the depreciation dedication. Instead, only “land improvements” are counted. This includes both the building itself and other land improvements, including driveways, parking lots, carports, paved areas, curbing walkways, sidewalks, site utilities, concrete stairs, fencing, block walls retaining walls, and even dumpster enclosures.
For example, if an investor purchases an apartment building for $20 million, and the base land is worth $2 million, they would only be able to take depreciation deductions on $18 million ($20 million - $2 million). Because multifamily properties are depreciated on a 27.5-year schedule, the investor can take an equal portion of depreciation deductions each year for each of the next 27.5 years ($18 million/27.5). This would equal approximately $650,000 in deductions per year.
It should be noted that, in addition to the purchase price of the property, certain closing costs can also be depreciated. Some depreciable closing costs include:
Legal fees
Title insurance
Surveys
Transfer taxes
Abstract fees
Utility installation service charges
Recording fees
It should also be noted that landscaping can also be depreciated, and can be segregated into different elements like tress, much, plants, and sod.
Accelerated Depreciation Allows Investors To Take Depreciation Deductions Faster
While straight-line depreciation is a great way for investors to lower their tax burden, it isn’t always the best way. While the IRS posits that buildings themselves depreciate over 27.5 or 39-year schedules, they admit that some building elements degrade faster. For example, you may need to replace an apartment building’s roof every 15 years. Therefore, they allow you to take depreciation deductions for these building components faster, in a process that’s called accelerated depreciation. Building components eligible for accelerated depreciation can usually typically be depreciated on a 5,7, or 15-year schedule.
If we take the same example from the straight-line depreciation section, and say, for instance, that 20% of the building could be depreciated on a 5-year schedule instead of a 27.5-year schedule, this would mean that an investor could take approximately $720,000 per year of additional depreciation deductions for that 5-year period. To compensate, the core straight-line depreciation amount would go down, but this would still significantly increase the velocity of tax deductions an investor would receive.
Unfortunately, however, if you’re an investor, the IRS is not simply going to take your word about how fast you think your building components are depreciating. Therefore, to take accelerated depreciation deductions, investors generally need to hire an engineering inspection firm to conduct something called a cost segregation study.
Bonus Depreciation Allows Investors To Take Up To 100% of Their Depreciation Deductions in One Year
Bonus Depreciation is a specialized form of accelerated depreciation permitted by the Tax Cuts and Jobs Act of 2017. Instead of permitting property owners to take relatively small depreciation deductions each year, it permits them to take 100% of the property’s improved value as an income tax deduction in one year. However, Bonus Depreciation won’t last forever-- it only applies to properties acquired by the end of 2022, so if investors want to take advantage of this opportunity, they should try to act fast.
Using a Cost Segregation Study to Take Accelerated Depreciation Deductions
To begin the process of getting a cost segregation study, an investor should contact and get quotes from several reputable cost segregation firms. A cost segregation study is not necessarily worth it for every situation, so if this is the case, a quality firm will generally tell the investor this. In general, the most ideal time to conduct a cost segregation study is in the year the building is built, purchased, or rehabbed.
Despite this, investors can have a “look-back” study conducted at any time and claim the resulting write-offs without changing their previous tax returns. If an investor has not held a building for a long time and planning to sell the building quickly, it may not be worth getting a cost segregation study, though there are always exceptions.
When it comes to choosing a firm, reputation is everything, because a poorly done study could lead to serious issues if an investor is ever audited by the IRS. A high-quality firm will not only do good work but will stand by their study and be available to speak with the IRS to defend their study should an audit occur or any other questions arise.
Investors may want to make sure that any engineer they hire to conduct a cost segregation study is certified by the American Society of Cost Segregation Professionals (ASCSP). An ASCSP-certified engineer will have a CCSP designation after their name and indicates they have gone through a well-regarded certification and training process.
The Length and Cost of Cost Segregation Studies
In general, cost segregation studies take 45-60 days to complete, depending on how quickly the inspection firm receives information from the owner/investor.
Cost segregation studies can vary in cost based on multiple factors, including building type, building size, and other considerations. Studies generally cost between $5,000 to $15,000, with higher fees for larger buildings, buildings with more tenants, lots of deferred maintenance, or unique structural complexities.
Depreciation Recapture: Paying Back The IRS
While depreciation is an amazing way for real estate investors to save money now, all great things must eventually come to an end, and depreciation (including accelerated depreciation) is no different. When an investor sells the property they took depreciation deductions on, they will need to pay the IRS back, in a process called depreciation recapture. However, money now is still far more valuable than money later, so taking these deductions is still highly valuable from a financial perspective.
Investors only need to pay the IRS back, however, if they sell the property for more than the “adjusted cost basis.” The adjusted cost basis is calculated by taking the original property cost and subtracting any depreciation deductions.
For example, if we take the example from the beginning of this article, if the investor sold the property after 5 years for more than $20 million minus depreciation deductions (let’s say these are 2.5 million), they would need to pay taxes based on the proceeds of the sale using their regular income tax rate, instead of the capital gains tax rate.
This isn’t ideal for investors, due to the fact the highest income tax rate bracket, as of 2022, is 37% for individuals earning $539,900 or more, compared to the highest capital gains tax rate is 20% for individuals earning $445,851 or more. These numbers are slightly different for married couples filing jointly, married couples filing separately, or individuals who are the “head of household.”
Therefore, continuing the example, if the investor sells the property for any more than $17.5 million, they would need to pay around $6.47 million on the property, assuming they can’t take any other tax deductions upon sale. However, there is a workaround, which we’ll mention next.
1031 Exchanges and Cost Segregation
If an investor is selling a commercial or multifamily property on which they have taken depreciation deductions and wishes to purchase a similar property of equal or greater value, they can utilize a 1031 exchange to defer their tax burden until the sale of the new property.
In fact, they can actually use another 1031 exchange to defer the taxes of the sale of that property as well. Some investors continue to “roll” new properties into 1031 exchanges for decades, or even their entire lives.
If you’re an investor and plan to do this, you should consider attempting to find a cost segregation firm with specific experience in 1031 exchanges. You will also want to work with a specialized 1031 exchange firm to help you with the process, as it can be complex, and involves a variety of specific rules and timelines that can be foreign to even the most experienced investors.
Other Common Tax Benefits for Multifamily and Commercial Real Estate Investors
While taking deprecation and accelerated depreciation deductions is typically one of the best tax moves an investor can make, it’s far from the only tax benefit offered by multifamily and commercial real estate investing. Other common tax benefits include:
Travel, Repairs, Maintenance Deductions: Inventors can generally take maintenance and repair costs, and travel to and from their properties (including hotel expenses and 50% of food and beverage costs) as deductions in the year in which these expenses are accrued. They may also be able to take deductions one education and event costs, such as attending seminars. Regular property improvements, however, need to be depreciated on their regular (or accelerated) schedule.
Real Estate Tax Loss Deductions: In the case that an investor actually loses money on a property and sells it at a loss, they can sometimes take a part of these losses as a tax dedication. This particularly applies to small investors making less than $100,000-$150,000 per year.
Mortgage Interest Deductions: Investors are allowed to take 100% of the interest they pay on their mortgage as a tax deduction. For example, if an investor had a $20,000/month mortgage, $7,000 of which was interest, they would be able to take $84,000 in tax deductions for that year.
IRAs for Real Estate Investment: If an investor utilizes a self-directed IRA for real estate investing, and sells a property after their required minimum age (generally 72) they will only pay income taxes, not capital gains taxes, on the property’s sale.
Qualified Business Income (QBI) Deductions: QBI deductions are a different type of dedication investors can take for passive income generated by real estate investments. The rules are extremely complex, so investors should check with a real estate accountant to learn more.
LIHTC and NMTC Programs: For larger real estate investors interested in affordable housing investment, the federal government’s LIHTC (Low-Income Housing Tax Credit) program permits investors in qualified low-income properties to take a 1:1 dollar deduction against their federal income taxes. Other similar tax credit programs include the New Market Tax Credits (NMTC) and Historic Tax Credit (HTC) programs.
Beneficiary Tax Deductions: If you plan to pass on commercial real estate to your heirs, your heirs will only pay taxes on the purchase price of the property, not its increased value. So, if you buy the apartment building in our previous examples for $20 million, and the value goes up to $40 million over a 15-20 year period (or less), your heirs will only pay taxes on the $20 million if and when they sell the property.
Opportunity Zones: The Opportunity Zones program is another part of the Tax Cuts and Jobs Act of 2017. It allows investors in real estate and small businesses who invest in low-income communities designed as official “Opportunity Zones” to defer their capital gains until December 31, 2026. However, to do this, they must either create or invest in an existing opportunity fund, a financial instrument that places 90% of its assets in commercial real estate or qualified businesses inside an Opportunity Zone. There are other benefits, including additional capital gains tax basis deductions, for investors who hold their investment for between 5-7 years.
In Conclusion: Depreciation is One of The Most Powerful Tax Tools For Real Estate Investors
No matter what type of depreciation deductions you take, as a real estate investor, depreciation is one of the most powerful tools to reduce your tax burden, increase your income, and enhance your ability to continue investing in real estate. However, depreciation rules, as with all tax policies, can be complex, which is why it’s essential to hire a qualified CPA with extensive real estate experience and other relevant professionals (such as 1031 advisors or cost segregation specialists) in order to guide you through the process. This way, you can maximize your potential deductions as well as prevent any mistakes or mishaps that could cost you financially, legally, or reputationally.