What is Real Estate Depreciation?

Real estate depreciation refers to the process by which investors deduct the costs of acquiring and upgrading an income-generating investment property over the time period in which the property can effectively generate revenue. This process of real estate depreciation allows investors to reduce their taxable income by writing off some of their investment expenses.

Real estate depreciation provides investors with a significant tax advantage compared to other investments which do not have an option for depreciation, as it allows real estate investors to reduce their taxable rental income through tax deduction.

Commencement of real estate depreciation

Real estate depreciation kicks in once the investment property is able to be used as a rental property. However, real estate depreciation only applies to the value of the physical structure of the property, not including the value of the land it is built on.

The property can continue to be depreciated until either all its costs have been deducted through tax deductions or the property is taken out of service or , sold, or demolished

Calculation of real estate depreciation

The calculation of real estate depreciation depends on the investor’s basis of the property, the depreciation period and the depreciation calculation method used.

Firstly, the basis of the property refers to the cost of acquiring the property, including any legal fees, closing fees, taxes, insurance, and any other fees involved in the transaction. The types of costs that are tax deductible may also vary, and these include fees such as additional loan charges, appraisal fees, costs for credit reports, and fire insurance premiums.

Secondly, the cost of the property should be separated into the cost of the built structures and the land itself. This is because only the built structures are depreciable, and not the land. The value of the buildings and the land can be calculated based on the market value, at the time of purchase or the assessed tax value of the property. This property value should be allocated to the buildings and the land to determine the deductible value of the building. This allows investors to separately determine their basis in the property and the building respectively. This basis can be adjusted if any additional renovations or repairs are made to the property, as well as the additional fees for these projects, which may impact the value or useful life of the property.

Most income-generating properties in the United States currently use the Modified Accelerated Cost Recovery System (MACRS) to calculate depreciation. This MACRS calculation system distributes the tax deductible costs that can be depreciated across 27.5 years, which the US Internal Revenue Service deems as the investment property’s useful life, during which it can effectively generate revenue.

The MACRS calculation system uses either the General Depreciation System (GDS) or the Alternative Depreciation System (ADS). Most active income-generating properties utilise the GDS, and this remains the default system for all properties unless there is a legal requirement or other obligations that require the investor to use the ADS.

The ADS is used only if the property is used for business purposes for at most half of the time, tax-exempt purpose, agriculture, or is funded by tax-exempt bonds.

Depreciation rate for real estate

Under the MACRS calculation system, the depreciation period is 27.5 years for income-generating residential real estate under GDS. Using the ADS, the depreciation period is 30 years or 40 years, depending on when the depreciation process begins. However, if a property does not go into service for a full year, the asset is depreciated at a lower percentage, depending on the commencement month. The following table depicts the depreciation rate by month.

Source: Internal Revenue Service (IRS)

These depreciation rates are reduced for partial years in service, compared to an annual depreciation rate of 3.636% for the years that the income-generating property is fully in service. This depreciation rate remains constant across the real estate depreciation period, provided that the property remains as an income-generating asset throughout its useful life.

How much does depreciation reduce tax liability?

Investor’s income and expenses for their rental property, as well as the net gains or losses are reported through their annual personal income tax filing. Real estate depreciation is calculated as an expense for the rental property, allowing the investor to write off the amount depreciation to reduce their tax liability. The dollar amount of the real estate depreciation for the year is then multiplied by the investor’s tax rate based on their tax bracket, providing them with a reduction in tax liability proportional to their tax bracket.

However, in the event the investor sells the property before the end of the real estate depreciation period, the investor is required to repay his tax deductions through a process known as depreciation recapture as part of the capital gains tax. Any profits made from the sale are taxed at the capital gains tax rate. With the sale of a depreciated property, the investor is responsible for a depreciation recapture tax of 25% on the difference between the original cost basis and the depreciated cost basis.

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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.