Real estate prices might be skyrocketing across the country right now, but for whatever reason, the IRS believes they are falling. In fact, they have believed they are falling for a long time and at a very consistent rate. If you just bought your house today, in 27 and a half years, the Feds will consider it worth nothing. If you just bought your office today, it will take a bit longer, 39 years, but the downward trajectory is the same.
And any “losses” you have because your property is “losing” value can be counted against any income the property produces, thus substantially reducing your income tax bill. This is the power of real estate depreciation.
So what exactly is going on here?
The Basics of Real Estate Depreciation
Everything wears out over time. Eventually, a furnace, A/C compressor, refrigerator, stove, computer, etc. will all wear out and become worthless. Before that time, of course, you can sell the item. But not for what you originally bought it for. As things get older they (usually) lose value. This is depreciation broadly defined.
This is true for cars too even though you can maintain them and even replace broken parts. Indeed, cars lose some 15 to 20 percent of their value as soon as they are driven off the lot! Of course, there are collector’s items and some vintage cars increase in value over time. But those are the exceptions that prove the rule.
The government considers real estate to lose value over time just like the things mentioned above. At least it considers the building or “improvement” to lose value. The land’s value stays the same. Usually, the improvement is considered 80 percent of the total property’s value and the land 20 percent.
The IRS sets the value of the property at whatever your purchase price is plus any capital rehab expenses. Then, over the next 27.5 years (or 39 for commercial) the improvement’s value goes down to zero. Each year, that depreciated value is considered a loss and counted against your income.
So if you buy a property for $275,000 (and let’s assume it’s all an improvement and no land for the sake of simplicity) and it brings in $10,000 a year positive cash flow, the taxable income from it is zero because it also had a $10,000 depreciation loss. ($275,000 / 27.5 years.)
Furthermore, if you are an active real estate investor (work at least 750 hours per year in real estate investment) you can count those depreciation losses against any income; whether it be from real estate or not.
This is obviously a huge tax advantage for real estate investors.
Paying it Back or Deferring Again
Of course, the government isn’t stupid (or not that stupid at least). They know real estate goes up in value over time if you maintain it. So the IRS will eventually want their money back. And they get it when you sell.
When you sell, the difference between the depreciated value and the purchase price (plus capitalized rehab expenses) will be taxed at the Depreciation Recapture rate (capped at 25 percent). Anything above the money you have into the property is taxed at the Capital Gains tax rate (capped at 20 percent).
While this is unfortunate, the longer you can defer a tax the better it is. The reason is that you can earn an additional return on the money that will eventually be taxed before the day comes when it is finally taxed away.
Furthermore, there are ways to defer taxes even longer. The most common is a 1031-Exchange where you can pass on the deferred gain into another property after selling the original. This is a great method although there is some talk of doing away with it.
Lastly, if you hold the property and pass it on to your children through inheritance, it can do so on a stepped-up basis, which basically restarts the entire process!
For these reasons, real estate depreciation can be a huge bonus for investors. It may sound like it’s digging deep into the accounting weeds, but that doesn’t mean it can be hugely profitable.