Depreciation: The Most Misunderstood Tax Benefit in Real Estate

The Tax Benefit – Depreciation

When you own rental real estate, the IRS allows you to depreciate the building portion of the property’s value over 27.5 years using straight-line depreciation. This means you can deduct an equal amount each year from your taxable rental income, reducing your current tax bill. To calculate depreciation, the property’s total value is divided into land and building values because land isn’t depreciable—only the building is. Typically, about 80% of the property’s value is allocated to the building and 20% to the land, though this can vary depending on location and appraisal. Depreciation not only lowers your taxes during ownership but also defers some taxes until you sell the property.

For example, if you’re in a higher tax bracket, say 30%, and you sell the property after seven years, you benefit by deferring taxes at that higher rate during those seven years. When you sell, the IRS “recaptures” the depreciation and taxes it at a maximum rate of 25%. So, in this scenario, you not only deferred taxes for seven years but also potentially saved 5% in taxes on the depreciated amount. Therefore, higher-income individuals often benefit more from depreciation because they defer taxes at a higher rate and pay a lower rate upon recapture.

The Catch – Depreciation doesn’t reduce your W2 Income

Depreciation from rental real estate typically does not reduce your W-2 income because rental losses are considered passive and can only offset passive income. The exception is if you qualify as a real estate professional under IRS rules. To meet this designation, you must spend more than 750 hours per year actively participating in real estate activities, and these activities must constitute more than half of your total working time. If you qualify, your rental losses—including those from depreciation—are considered active losses and can offset other forms of income, such as W-2 wages. This can be especially advantageous if your spouse has W-2 income; your real estate losses can reduce your combined taxable income, potentially lowering your overall tax liability. However, it’s important to note that unless you meet the real estate professional criteria, depreciation cannot be used to reduce other income such as stock gains, salary, and bonus income.

Using Depreciation from Multiple Properties and Syndications to Offset Passive Income

When you own multiple rental properties or invest in real estate syndications, the depreciation from one investment can offset the income from another. For example, suppose you have a fully paid-off rental property that’s generating substantial cash flow and taxable rental income. This income is considered passive income. If you also invest in a real estate syndication, such as an apartment complex, the syndication may pass through significant depreciation expenses to you, often higher due to accelerated depreciation methods. These depreciation deductions are also considered passive losses. You can use these passive losses to offset the passive income from your paid-off property, effectively reducing your overall taxable income from your real estate investments. This way, the depreciation from the syndication helps to lower the tax liability on the gains from your other properties.

Conclusion

In summary, understanding how depreciation works is key to maximizing the tax benefits of real estate investing. While depreciation can reduce your taxable rental income and defer taxes, it generally doesn’t lower your W-2 income unless you qualify as a real estate professional. However, you can use depreciation from multiple properties or syndications to offset passive income from other real estate investments. Always consult a tax professional to understand how these strategies apply to your individual situation and to ensure you’re making informed decisions.

Investments, Multifamily Education, Real Estate, Real Estate Education