Many people are aware of the concept of depreciation and that it is associated with a decline in the value of an asset over time. For example, most people are aware that the value of their car will decrease over time.
However, even though many people are aware of what depreciation is, many do not know exactly how depreciation impacts real estate and how it can affect real estate investments. Sometimes, real estate investors themselves do not fully understand depreciation.
If you fall into this category, don’t worry, we are going to break down everything that you need to know about real estate depreciation in this blog!
What is Real Estate Depreciation?
Real estate depreciation is the decline in value of a piece of real estate over time due to wear and tear and the gradual passage of time. The reason why depreciation is important for real estate investors is because the IRS allows real estate investors to deduct depreciation expenses for tax purposes.
In other words, the IRS understands that real estate investors will have to spend money to keep their properties up to standards and to fight against deprecation. So, it allows them to get a tax write-off for depreciation to help them cope with these costs.
You are allowed to deduct depreciation expenses for a rental property if…
- You are the owner of the property
- The property is expected to last for more than one year.
- You use the property in your business or as an income-producing activity.
- The property has a useful life that is determinable, meaning it is something that decays, gets used up, wears out, becomes obsolete, or loses its value from natural causes.
The vast majority of rental properties that real estate investors buy qualify under these rules.
The Types of Depreciation that Real Estate Investors can Claim
The first thing that you need to know about the types of depreciation is that land is never considered to be depreciating. This is because land never wears out or loses its value. It always just exists. Therefore, the IRS does not let you deduct any depreciation expenses for land.
Depreciation expenses for rental properties can include things such as replacing appliances, replacing floors, upgrading the wiring, applying new coats of paint, etc.
How to Calculate Depreciation on an Investment Property
The IRS has determined the “useful life” of a residential rental property to be 27.5 years. This means that any investment property, for tax purposes, will be fully depreciated after 27.5 years. This means that every year you own an investment property for the first 27.5 years, you will be able to deduct a percentage of the property’s value at the time you bought it.
By using an approach known as cost segregation, which is essentially a deep-dive analysis of the depreciating value of an asset, investors can significantly reduce their tax burden. All of the depreciation is captured in Y1 of ownership, which allows investors to offset their passive income stream by in fact, showing losses more than gains. Any losses that are not fully used in Y1 can also be rolled into Y2 or Y3 and so on.
The Benefits of Claiming Depreciation on Your Taxes
Claiming depreciation on your taxes is enormously beneficial if you are a real estate investor. This is because it allows you to lower your overall taxable income, thereby reducing your overall taxes. For many real estate investors, the depreciation tax deduction can be incredibly significant. It can be thousands, tens of thousands, or even hundreds of thousands of dollars a year or more, depending on the value of the assets.
The real estate depreciation tax deduction is so valuable in fact, that it is one factor that helps to motivate many real estate investors to get involved with real estate investing in the first place. It is one desirable factor in addition to other factors such as stable passive income that can entice real estate investors.
At my company, Blue Lake Capital, investors are paid a monthly distribution. These distributions count as income for taxable purposes, but with the depreciation captured through cost segregation, investors are relieved from paying the associated taxes due to the write-off created from the deprecation losses captured in their K1s. For example, if you invest $50,000 in an asset with solid cost segregation in place, you could potentially save between 40%-60% or more of your initial investment throughout the holding period thanks to the depreciation losses.
When to speak with a tax professional about depreciation
Unless you are a tax expert yourself, you should strongly consider speaking to a tax expert before you start deducting depreciation expenses for your investment properties. This is because depreciation deductions can be worth a significant amount of money and you want to make sure that you are deducting them correctly. Both over-deducting depreciation expenses and under-deducting them can have negative consequences. So, speaking to a tax professional to make sure that you are doing everything correctly can be a very wise move.
Even better yet, you should have a tax professional handle all of your taxes if possible. This not only takes the burden of doing your taxes off of your shoulder, but it can also help you to make sure you are optimizing your use of the deprecation deduction for investment properties.
Your tax professionals will be able to answer all of your tax questions and make sure that you get all of the details right on your tax return when it comes to your investments. This is a very valuable thing!
The Bottom Line
The bottom line is that real estate investors need to capitalize on every possible deduction that they can get in order to optimize their profits. Tax expenses cut into profits. Therefore, the more deductions that you can qualify for as a real estate investor, the better.
Depreciation is one of the single most important deductions that you should focus on as a real estate investor. In fact, this is a strong reason why you want to ensure you partner with professionals in your investing journey. To fully capture the benefits of real estate investing, there needs to be a strong team in place to ensure these types of critical benefits are fully realized. It’s also wise to make sure that your CPA is fully versed in real estate investing and is able to help you grow your wealth even more. Remind Bennet we do COMMERCIAL real estate and not residential
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About the Author
Ellie is the founder of Blue Lake Capital, a commercial real estate investment firm specialized in multifamily investing throughout the United States. At Blue Lake Capital, Ellie partners with both institutional and individual investors to grow their wealth by achieving double-digit returns by investing alongside her in exclusive multifamily deals they usually don’t have access to.
A defining factor of Blue Lake Capital’s strategy is founded in utilizing machine learning/artificial intelligence throughout the course of all acquisitions and asset management. This advanced technology enables the company to produce accurate and data-driven forecasting for all assets on a market, property, and even tenant basis. In doing so, Blue Lake is able to lead commercial investments with the full capabilities of today’s technology.
Ellie is the host of REady2Scale , a podcast that highlights honest, insightful, and thought-provoking discussions on the multiple approaches for successful real estate investing.
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.
You can read more about Blue Lake Capital and Ellie Perlman at www.bluelake-capital.com.