Depreciating Income Property

When investors buy properties, most of them focus on the cash flow they can receive from the property. However, sometimes there are even bigger benefits that are often overlooked. Using depreciation on investment properties is a time-tested wealth preservation tool.

While it would seem nice to be able to just write off the entire purchase price when the property is purchased, there are 2 major issues with that. First is that when you are first starting out, you will often not have enough income to offset the deduction, so you would lose the benefit of the deduction as the IRS will not pay you for a loss. The second (and maybe more important) reason is that the IRS does not allow you to deduct the entire property in one year. The IRS does allow you to use depreciation, which is the process used to deduct the costs of buying and improving a rental property.

To depreciate property, it must meet the following criteria:

  • You own the property. (You cannot depreciate property you are leasing.) It can have liens against it such as a mortgage, but you must be on the deed.
  • It must be used in a business or income-producing activity.
  • It must have a determinable useful life. (It is something that wears out, decays, gets used up, becomes obsolete or loses its value from natural causes.)
  • It must be expected to last more than one year.
  • It must not be excepted property.
  • It must not be excepted property. (It can’t be depreciated if you placed it in service and disposed of it (or no longer use it for business use) in the same year. Land isn’t considered depreciable. And in general, you can’t depreciate the costs of clearing, planting, and landscaping, as those activities are considered part of the cost of the land.

Historical Way To Depreciate:

To depreciate a property put into service (start renting) after 1986 you will use the “Modified Accelerated Cost Recovery System” (MACRS). MACRS provides for two different methods for depreciation: GDS and ADS. We will discuss GDS as that is the most commonly used method but consult your accountant to determine the best method for you. GDS is the IRS approved accounting technique that spreads the costs of the property over 27.5 years (which the IRS considers to be the “useful life” of a rental property). You will take the cost of the property and subtract the value of the land (excepted property that doesn’t wear out) and divide that by 27.5 to get the amount you can depreciate on your taxes for the year.

(Cost of the Property) – (Value of the Land) = (Building Value)

(Building Value) / 27.5 = (Yearly allowable depreciation deduction)

Example: paid $150,000 for property, land value is $25,000

$150,000 -$25,000 = $125,000

$125,000 / 27.5 = $4,545.45 Depreciation on taxes.

For years that are not a full year, prorate it for the amount of time in the year it was available for rent. As with any tax deduction, how much benefit it provides will be determined by the tax rate that it is applied in. So, the higher your overall income, the bigger advantage it will provide you. By allowing you to depreciate the property over multiple years, the IRS is helping you apply the deduction to the higher level of taxes thus giving you a greater benefit. Of course, if you depreciate a property and then sell it for more than its depreciated value, you will owe tax on that gain through the depreciation recapture tax, but there are ways to negate that, such as a 1031 exchange, but that is for a later discussion.

Cost segregation Method:

Cost segregation is the method of re-classifying components and improvements of your commercial building from real property to personal property. This process allows the assets to be depreciated on a 5, 7 or 15 year schedule instead of the traditional 27.5 or 39 year depreciation schedule of real property. Thus your current taxable income will be greatly reduced and your cash flow could increase by 5% – 8% of your building’s cost*.

Summary:

This overall topic of depreciation can be somewhat challenging I admit. If you have commercial, multi family or apartments it can be even more confusing. We suggest working with a specialist in this field. It is in your best interest since tax savings will offset the cost of a study and a detailed analysis of your property. If you are already into commercial properties this is especially important in our opinion. There may be substantial savings you could take advantage of before you sell by depreciating most of your deductions on the front end.

Are you completely confused yet as to how you would take advantage of this? The Flip Sharkz have you covered, we have already made great connections with a specialist in this field. Our friend and trusted colleague in the Cost Segregation business is Jason K. Cummings at CSSI. Jason can be reached at 541-513-1338 or email at jason1cummings@gmail.com

Like always if you have any questions you can always give the Sharkz a call at 541-780-2424 and we will be happy to answer any questions you may have.

 

 

*Courtesy of CSSI.

 

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