The Real Estate Depreciation Simplified
In the long run, real estate tends to increase in value. For instance, a house that was purchased for $100,000 approximately 10 years ago would now have a significantly higher value in most parts of the United States, assuming it has been properly maintained during that time. However, this is where the importance of proper upkeep comes into play. What does it mean to keep a property well-maintained? It entails tasks such as replacing worn-out roofs, repainting the house, addressing plumbing issues as they arise, and upgrading the electrical panel, among other necessary maintenance tasks. This highlights the fact that periodic work is required to ensure that the property remains in good condition. While the value of the land may appreciate, the building itself undergoes wear and tear, necessitating repairs and upgrades.
Fortunately, the IRS recognizes this aspect of real estate investing. Consequently, they allow property owners to depreciate the building cost of a house, apartment, or any other type of real property over a span of several years. In the case of residential properties like houses or apartment buildings, the IRS permits a depreciation period of 27.5 years. For example, if the building cost of your property amounts to $500,000 (particularly relevant in a state like California), you can depreciate $18,181 annually. In simpler terms, this means that you can deduct $18,181 from your taxable income each year, effectively creating a paper loss of the same amount.
Now, let’s consider a scenario where your property generates $10,000 in income. However, due to the paper loss resulting from depreciation, your net income for tax purposes that year would be $10,000 minus $18,181, resulting in a deficit of $8,181. On paper, for tax purposes, you would have a net loss of $8,181. Essentially, this implies that the $10,000 income you earned from the property would be tax-free!”
Note: While the above information provides a general understanding of depreciation in real estate, it’s essential to consult with a tax professional for accurate and specific advice regarding your individual circumstances.
What can you do with the remaining loss of $8,181? There are several options available. If you own other properties that generate more income than the paper losses they produce, you can utilize this paper loss to offset that income. Alternatively, if you do not own any other properties, you can accumulate this paper loss and deduct it from the gain when the property is eventually sold, reducing the taxable gain. Additionally, if your income falls below a certain threshold, you may even use this paper loss to offset your W-2 income. However, it’s important to note that this may not apply to the majority of real estate investors, especially those who invest in apartment syndications.
To be precise, the term ‘tax-deferred’ is more accurate when referring to the $10,000 income. It means that the taxes on this amount are postponed and will be applicable later as part of the depreciation recapture mechanism established by the IRS, specifically upon the sale of the property. The IRS will tax the portion of the gain equivalent to the total depreciation taken at the time of sale. However, there is good news – this gain is subject to a special tax rate of 25% as of the time of writing this article. If your income is higher, and you would typically be taxed at a higher rate, say 39%, upon the property’s sale, you would only have to pay the amount written off as depreciation at the lower rate of 25%, resulting in a significant tax savings of 14%!
Therefore, depreciation not only allows you to defer your taxes, but it also has the potential to reduce your overall tax liability. This is why it is considered one of the significant benefits of real estate investing.
Depreciation for People Investing in Syndications
Now let’s consider the case of passive investors. Even if they are solely investing in apartment syndications as a Limited Partner, they can still enjoy the advantages of depreciation. In many cases, the General Partners will allocate the depreciation to them based on their ownership percentage in the property. This allocation will be reflected on the IRS Schedule K-1 they receive during tax time. Consequently, they will be able to offset the cash flow generated from the apartment syndication in the same manner as described earlier!