Property depreciation shelters your financial returns on real estate investment assets from annual tax fees. This can result in significant cost-savings for you each year. Although you may be required to repay this amount on a future year’s tax report if you sell a property without exchanging, you will most likely owe a lesser tax assessment at that time.
This tax deferral due to depreciation enables you as a property owner or passive investor in syndication investment deals to defer some tax payments until a later time. This can put more “after-taxes” funds in your pocket for the immediate year.
What Depreciation Is and How It Benefits Property Owners
Depreciation is defined as a reduction in value caused by wear-and-tear, deterioration or a decrease in price. For property owners and investors, depreciation allows a tax loss write-off for the current tax payment year. Your business costs versus your capital expense distinction is a well-known comparison to property owners and investors who pay close attention to their annual tax returns.
As an owner of a large multifamily apartment building, or as a passive investor in this type of property through a real estate investing (REI) syndication, you know that you can write off plumbing renovations as a business expense. Yet installing new roofing or exterior building siding is a capital expense.
This capital expense is required to be depreciated over multiple years (for example, 27.5 years). Since property typically will not decline in value over time, it requires ongoing maintenance. Due to this fact, a tax deduction for property depreciation is granted to property owners and investors.
Why You Cannot Depreciate All of Your Real Estate
Land is considered an inexhaustible asset that does not depreciate over the years. You may have invested $1 million in a large multifamily complex. Yet at tax time, you cannot depreciate this total amount since the land on which the complex sits is not depreciable.
In order to receive the optimal tax advantage, you must estimate the property value percentage that is allotted for improvements. Then multiply this figure by your initial purchase (or investment) amount. You can then depreciate the resulting amount over multiple tax years. As an example, if your percentage equals 75 percent, you can depreciate 75 percent of $1 million, or $750,000, throughout the remaining depreciable life of your investment property.
How to Estimate the Percentage of Property Depreciation
Your accountant or tax professional can determine the percentage of your investment property depreciation for you. An allowed reasonable estimation of this figure is often used by these financial experts. You should not estimate this amount based on your property tax bill, however.
The reason for not using your tax bill for calculating this estimate is that the assessor’s office bases the amount of the percentage tax you are charged on the property value. They are not concerned about what percentage is allotted for improvements and what percentage represents the land.
Depreciable Life of Large Multifamily Properties
Large multifamily apartment complexes of as many as 3,000 units are depreciated over 27.5 years. If you invested $1 Million in a large multifamily property, you can claim $1 million multiplied by 75 percent ($750,000) divided by 27.5, which equals $27,273 per year for the next 27.5 years as a valid property depreciation tax deduction.
If you are a limited partner (passive investor) in a syndication multifamily property investment that is valued at $500,000, this property shows a depreciation expense equaling $18,182 annually ($500,000 divided by 27.5). If this multi-unit property generates an income of $80,000 each year, your tax payment owed will equal the following:
Taxes Owed Before Depreciation: $80,000 x 25 percent (federal income tax) = $20,000
Taxes Owed After Depreciation: ($80,000 – $18,182) x 25% = $15,455
These calculations enable you, as a passive investor, to save $4,545 every tax year before further benefits from adding other allowed deductions.
Accelerated Depreciation for Faster Tax Savings
Different types of asset improvements are depreciable at varied rates. For instance, if your large multifamily investment property is updated with ensuite baths for the master bedrooms in each unit, these improvements can be depreciated over 27.5 years. Yet if new carpets, window blinds or appliances are installed in each apartment, they can be depreciated over five years. These regulations enable you to receive valuable tax savings sooner.
Importance of Understanding the Basics of Depreciation
Savings from depreciation actually account for a sizable portion of a successful real estate investor’s after-tax profits. For this reason, it is essential for every investor in multifamily properties to have a good understanding of the fundamentals of property depreciation.
With the efficient and effective use of depreciation, you, as a passive investor, can build your profits more rapidly and steadily by receiving after-tax funds for future investing.
More Aspects of Real Estate Depreciation Tax
Most experienced passive investors (limited partners) in syndication multifamily property investments consider depreciation as one of the most valuable tax shelters. Depreciation is based on the principle that any property depreciates over the years. The amount of depreciation is a valid tax deduction that includes a property’s wear-and-tear, or exhaustion, over time.
New investors in multi-unit apartment buildings or complexes often wonder how a property depreciates, or declines, as its market value increases over time. To the IRS, the quality of a property as an asset decreases progressively just as the value of a car is reduced over time.
However, if a property is well maintained and is located in a progressive, growing locale, the value of this real estate will increase as well. For this reason, the owners (or investors in) this property are permitted by the IRS to deduct a depreciation expense amount from their real estate income tax owed. This holds true whether the property generates a profit or appreciates in value or not.
Additional Benefits from Cost-Segregation
Cost-segregation has similarities to depreciation. The main difference is that cost-segregation includes the value depreciation of specific factors in multi-unit properties. IRS regulations assign shorter lifespans to such items within properties, such as cabinets, appliances and fixtures.
For this reason, the IRS permits real estate investors in multifamily properties to write off depreciation expenses for these items during a 7-year period. As an example, if you are a passive investor in a syndication property investment that is valued at $500,000 and has cabinetry, appliances and fixtures that have a total value of $100,000, your depreciation expense will be calculated in the following manner:
Property Value = $500,000 – $400,000
Property Depreciation Expense = $400,000 / 27.5 = $14,545
Cabinetry, Appliance and Fixture Depreciation Expense = $100,000 / 7 = $14,286
Depreciation Expense Total = $14,545 + $14,286 = $28,831
By comparing your property depreciation expense with the cost-segregation, you can see that cost-segregation actually provides you with a higher tax shelter. However, cost-segregation typically impacts your tax bill at the time that you sell your property. The more you make use of cost-segregation for its tax shelter benefits, the higher your tax bill will be at the time of your property sale.
Benefits of 1031 Exchange Tax
According to the IRS Code, section 1031, real estate investors can swap their multi-unit rental properties with minimal capital gains tax obligations and sometimes none at all. Yet in order to qualify for this benefit, investors must meet the following requirements:
- The new property is required to have an equal or greater value when compared to the old property.
- The swapped real estate is required to be used for productive business activity.
- The two properties must be of the same or similar type.
Passive Income Tax Advantages
If you spend over 500 hours each tax year on real estate, the IRS considers you a real estate professional. Yet if you spend less time on your REI projects annually, you are not classified as a real estate professional for tax purposes. There is actually a passive income tax benefit for multifamily property investors who are not real estate professionals.
Non-professional property investors must pay passive income tax rather than normal income tax. When their investment properties appreciate in value, they owe capital gains taxes. However, both passive income and capital gains tax rates are typically lower than federal income tax rates. As a result, as a real estate non-professional, your taxes on multifamily property investments will be significantly lower than for professionals.
As you can see, by performing some due diligence and using some good tax strategies, you can enjoy some impressive tax breaks on your investments. With the use of these attractive and cost-saving benefits, you can greatly reduce your tax obligations on your multifamily property investments as a passive investor.
Concluding Thoughts
Tax deferral allowances by the IRS due to real estate depreciation enable passive property investors in syndication deals to defer some tax obligations until a later date. This can result in significant cost savings as “after-taxes” funds for you as a passive property investor for the immediate year.
Once you understand the basics of depreciation and how to estimate an investment property’s percentage of depreciation, you are on your way to gaining significant tax advantages on your passive REI deals. By gaining knowledge about cost-segregation and the 1031 Exchange Tax, you can enjoy greater cost-savings on property taxes.
As a passive real estate investor in syndication multifamily property investment deals, you can gain many lucrative tax benefits that will build your investment portfolio and generate higher profits. You can then enjoy the multiple rewards of being a savvy and successful passive investor.