How to Benefit from One of the Greatest Tax Shelters: Depreciation

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Many people are unaware of the true power of depreciation to shelter income from taxation. Or if they are aware, they think that depreciation is only something big business can benefit from.

Both statements are far from the truth!

Depreciation is simply an accounting method used to allocate the cost of a tangible or physical asset over its useful life. You see, the IRS is aware that tangible and physical assets break down over time. Since the IRS understands that these types of assets will eventually need to be replaced, they allow the business owner to recoup the cost of replacing the asset over a specified period.

And since real estate assets (i.e., buildings and improvements) count as tangible and physical assets in the investment, depreciation applies to real estate as well!

Why is Depreciation Powerful?

For most accredited investors, your personal tax is one of your largest expenses. To compound the issue, every dollar you spend on taxes is a dollar you cannot invest.

When you invest in passive real estate (like a syndication) the tax write-offs from depreciation (aka passive losses) can pass through to you.

Furthermore, these passive losses can offset the passive income generated not only on the asset you initially invested in, but you can also use those passive losses to offset passive income and passive gains generated by other assets in your portfolio.

The true power of depreciation is it allows you to accelerate the time value of money.

So how does depreciation work for you?

Good, Better, Best: The Three Kinds of Depreciation in Real Estate and How They Work

There are three kinds of depreciation, and they all affect the ability to allocate the cost of a tangible or physical asset’s useful life in different ways.

Straight-line Depreciation

Straight-line depreciation is the simplest method for calculating how a tangible or physical asset will break down over time. With this method, the same amount of depreciation is deducted from the value of the asset for every year of its useful life. These timelines differ for assets. For  residential assets such as multifamily, the useful life of a multifamily building is 27 1/2 years (whereas the useful life of a self-storage building is 39 years).

For example, if you purchase a residential multifamily property for one million dollars, and $200,000 of that purchase is the land value, the IRS states that the useful life of that property is 27 1/2 years since it is a residential asset. When using straight-line depreciation, the tax write-off each year would be $29,000 ($800,000 ÷ 27.5 years).

Accelerated Depreciation

Accelerated depreciation allows greater depreciation to be taken in the earlier years of the life of an asset. The simplest way to determine what can be accelerated forward is to perform a cost segregation analysis. The goal of a cost segregation analysis is to identify any components of the real estate asset that depreciates in 20 years or less (according to the IRS) and claim (or accelerate) as much of that depreciative loss to the first five years of the hold of the asset.

Using our same multifamily purchase example above, you purchase the building and decide to do a cost segregation analysis. In the analysis, the engineer identifies that $200K in components on the asset would depreciate in 20 years or less, therefore they could be accelerated forward to years one to five of the hold. Instead of taking a straight-line depreciation of $29,000 in year one, you could take a write-off of $69,000 in years one to five ($200,000 ÷ 5 (years) = $40,000; $40,000 + $29,000 = $69,000).

Bonus Depreciation

Bonus depreciation is a tax incentive that allows a business to immediately deduct a sizable percentage of the purchase price of eligible assets and rather than writing them off over the useful life of that asset, the business can take that entire write-off in year one. With the 2017 tax cuts and job act, bonus depreciation increased from 50% to 100% (yes!). However, this increase is due to phase out in the next three years. But for 2022, bonus depreciation is still 100%, so back to our multifamily purchase example, instead of taking the additional $200,000 write-off over five years, you could effectively take it all in year one.

As mentioned, bonus depreciation is phasing out over the next few years and will decrease from 100% to 80% in 2023. This does not mean that depreciation is going away! In none of these scenarios, have we changed how much depreciation is taken over the useful life of the asset. We have only changed when it is taken.

How to Benefit from Depreciation as a Passive Investor

When you invest as a limited partner in a passive asset, you are an equity owner in the business that owns the asset. One of the benefits of ownership is that depreciative losses can pass through the entity to you as the individual investor. (I say “can” because investors must be aware that some operators do not pass through these benefits to their investors.)

So how does all this depreciation at the asset level benefit you as a limited partner investor?

Let us say you invest $100,000 into a passive real estate asset that throws off a 50% depreciation benefit in year one and you are paying 37% tax since you are a high-income earner. In year one, you will have $50,000 in depreciative losses to use to offset the passive income and passive gains across your portfolio ($100,000 x 50% = $50,000). Since you are paying 37% in tax, that $50,000 in losses will generate a tax write-off of $18,500 for every $100,000 invested ($50,000 x 37% = $18,500). Another way to look at it is the $18,500 write-off equates to an 18.5% first-year return just from the tax savings generated by the passive investment.

Moreover, this write-off can be used to offset any passive income or passive gains generated by this individual investment, and it can shield other passive income and passive gains generated in other parts of your portfolio.

More losses, please!

What the IRS Giveth, They Can Take Away… Sort Of

When you invest in real estate, the IRS requires you to take depreciation, which means you are now in partnership with the IRS. If you hold the asset, you get to benefit from the depreciation (yes!). However, when that asset sells, your “partner” (the IRS), will want to recoup its investment in the asset through a depreciation recapture tax (no boos yet!).

While a depreciation recapture tax may sound like a scary thing, what most investors do not realize is that the recapture tax is only on the amount of depreciation taken to date, not on the depreciation of the entire asset (for those who took advantage of bonus depreciation, that may not put you at ease still).

However, the IRS incentivizes investors like you to keep your investment dollars working hard, so they give investors a couple of ways to sidestep this recapture tax through the 1031 exchange as well as the ability to use other passive losses (even suspended losses) to offset any recapture tax (aka the “Lazy” 1031 exchange).


Wrapping Up

I completely understand if your head is spinning right now. Mine did too when I first tried to understand not only what depreciation was, but how it could help me build wealth!

It didn’t take me long to realize that depreciation is the number one way the wealthy legally reduce their taxes, keep as much of their hard-earned dollars working for them as possible, and accelerate the time value of money.

The question is, are you taking full advantage of the power of depreciation?