Level 22: Income Tax in Real Estate - Chapter 5: Depreciation

Depreciation Is Not a Choice

Depreciation is sort of confusing because it's not actually related to what is going on with your property. It's just a construct that the IRS uses for business tax purposes. It doesn't matter if your building is in great shape or increasing in value: In the eyes of the tax authority, it is depreciating. Even if a taxpayer doesn't claim depreciation on a property, they still have to pay the depreciation recapture tax when they sell it. It's not up to you: That property is depreciating. So you might as well claim it!

What Does Depreciation Actually Do, Anyway?

Depreciation takes value away from your basis. Every time you depreciate the property in the example, your depreciable basis is exactly $15,454.55 less than before. The idea is that it will eventually be zero. It also gives you a tax deduction every year. The amount you depreciate your home is tax-deductible through a deduction called the depreciation deduction. (The IRS is not trying to get cute with the deduction names, okay?)

Chapter 5 Key Terms

Here are some handy key terms for Chapter 5: ✏️ tax depreciation: a way to recapture the loss in value of an asset over time by writing off a portion each year ✏️ straight-line depreciation: an accounting method used to figure depreciation that allows the taxpayer to deduct the same amount every year of the asset's useful life ✏️ recaptured depreciation: the tax owed at the time of sale on depreciation taken during an asset's holding period

How Much Is Your Land Worth? Example

It's a little confusing, so let's look at an example. Let's say Rob paid $500,000 for a property. He needs to figure out how much his land is worth, so he pulls up his handy dandy tax assessment. It says this: Improvements...$300,000 Land...$100,000 The total assessed value of his property is $400,000. $300,000 (the value of the improvements) + $100,000 (the value of his land) = $400,000. Divide the value of the land by the total value to get the percentage of value : $100,000 ÷ $400,000 = 0.25 (Remember how to get percents? Just multiply by 100, so 0.25 x 100 = 25%). Rob's land is worth 25% of the value of the property. Since Rob paid $500,000 for the property, he needs to figure out what 25% of that is to get the value of the land. $500,000 x 0.25 = $125,000 (You may remember how to do this from the math chapter, but if not: Find a percentage by multiplying the number you want to get a percentage of [500,000] by the percent you want, divided by 100 [25 ÷ 100 = 0.25]. Yes, that's the reverse of what we just did. Feel free to skip the multiplying/dividing by 100 step. Just trying to make it clear. Rob's land is worth $125,000, so he'd subtract $125,000 when figuring his depreciable basis.

What Is Depreciation, Anyway?

It's the moment you've been waiting so long for, Mustafa. It's time to learn about depreciation! 📢air horn sound 📢 Depreciation is the opposite of appreciation. But only for tax purposes. Don't go around telling people you depreciate their tone. Tax depreciation is a way to recapture the loss in value of an asset over time by writing off a portion each year.

Depreciation Example

Let's keep going with this example to make this whole depreciation thing a little more clear. Say the building is a residential building, and his acquisition costs were $50,000. To find his depreciable basis: $500,000 + $50,000 - $125,000 = $425,000 Since it's a residential building, his cost recovery period is 27.5 years. $425,000 ÷ 27.5 = $15,454.55 So every year, he would depreciate his building by $15,454.55 until, 27-and-a-half years hence, it's fully depreciated.

Finding the Depreciation Allowance Example

Let's look at an example. Catelyn buys a commercial building for $800,000. Her closing costs are $60,000. She figures out that her land is worth $200,000 (more on how to figure that out later). What is her annual depreciation allowance? We find her depreciable basis by adding the closing costs to the cost of the property, then subtracting the value of the land. $800,000 + $60,000 - $200,000 = $660,000. Since it is a commercial building, its recovery period is 39 years. $660,000 ÷ 39 = $16,923.08. Every year, Catelyn would depreciate her building $16,923.08 (and deduct $16,923.08 from her taxes).

Math Workshop: The Wall (Depreciable Basis)

Now it's your turn to give depreciation a try! Here's the scenario: Ygritte purchased The Wall, a commercial property in North, North Westeros, for $1,300,000. She paid $40,000 in closing costs, and had to make $100,000 in improvements before she could rent any of the office suites. Based on a tax assessment, she determines the land she purchased is worth $150,000. Can you help Ygritte determine her depreciable basis? Answer: $1,290,000 Explanation: To find the depreciable basis, we use the formula Depreciable basis = Purchase price + Acquisition cost + Renovations - Land value $1,290,000 = $1,300,000 + $40,000 + $100,000 - $150,000 Possible error: You may have forgotten to subtract the value of the land, or maybe you forgot add the acquisition cost or the renovations. Or maybe you just did the math wrong. Hey, Mustafa, none of us are perfect, not even me (though my robot brain is very good at math). Let's keep going with Ygritte's property. We determined that her depreciable basis is $1,290,000. Given that we know her property is a commercial property, can you help her find her annual depreciation allowance? Answer: $33,076.92 Explanation: To find the annual depreciation allowance, we have to remember that commercial properties are depreciated over 39 years. Then, we just divide. Depreciation allowance = Depreciable basis ÷ Recovery period $33,076,92 = $1,290,000 ÷ 39 Possible error: You may have used the depreciation period for residential property (27.5 years) instead of commercial property (39 years).

What Can Depreciate?

Only investment properties depreciate — you can't claim depreciation on a primary residence. Generally, property (including items like computers) used for business purposes are depreciable. Here are the rules about what can depreciate, according to the IRS: It must be property you own. It must be used in your business or income-producing activity. It must have a determinable useful life. It must be expected to last more than one year.

One More Depreciation Example for Good Measure

Since figuring out depreciation is math on math on math, let's look at another example allllll the way through the depreciable life of a building, just to make sure everything's clear. Jon buys a residential investment property for $750,000. His closing costs are $40,000. Before he puts the building into service, he does $100,000 in improvements to it. To figure the depreciable basis, Jon needs to know how much his land is worth. He looks at his tax assessment. It reads: Land...$150,000 Improvements...$450,000 The total assessed value of his property is $150,000 + $450,000 = $600,000. $150,000 ÷ $600,000 = 0.25 0.25 x 100 = 25% Jon's land is worth 25% of his property. Jon paid $750,000 for the property, so to find the dollar value of his land for the depreciable basis, he needs to calculate 25% of $750,000. $750,000 x 0.25 = $187,500. The dollar value of Jon's land is $187,500. To find his depreciable basis, he adds his acquisition cost (the basis), closing costs, and improvements, then subtracts the value of the land. $750,000 + $40,000 + $100,000 - $187,500 = $702,500. That is his depreciable basis. Since it is a residential building, its depreciation recapture period is 27.5 years. Jon divides his depreciable basis by 27.5 to get his annual depreciation allowance: $702,500 ÷ 27.5 = $25,545.45 Every year, he depreciates his building by $25,545.45 (and deducts $25,545.45 from his taxes). This goes on for seven years. Then Jon has some urgent business to take care of up north and has to sell his property. He sells it for $1,500,000, and it costs him $200,000 to sell it. $1,500,000 - $200,000 = $1,300,000 is his realized gain. To find his adjusted basis, he adds his purchase price plus closing costs plus improvements minus depreciation. Remember, the value of the land is okay to include here, unlike for the depreciable basis. The total depreciation Jon took during the holding period was: $25,545.45 x 7 = $178,818.15 So his adjusted basis is: $750,000 + $40,000 + $100,000 - $178,818.15 = $711,181.85 Whew. Okay. So to find Jon's taxable capital gain, we subtract his adjusted basis from his realized gain: $1,300,000 - $711,181.85 = $588,818.15. Jon will have to pay capital gains tax on $588,818.15 in profit (since it's an investment property, he's not eligible for any exclusion). But that's not all! He also has to pay that pesky depreciation recapture tax. Remember that depreciation recapture is 25% of the total depreciation he has claimed during the holding period. $178,818.15 x 0.25 = $44,704.54. That's how much Jon will pay in recapture depreciation. And that's it. Depreciation. Make sense? I hope so, Mustafa, because test time is coming...❄️

How Much Is Your Land Worth?

So if you have to subtract the value of your land from the purchase price to get your depreciable basis, how do you know how much your land is worth? If you catch a leprechaun and refuse to release him, you can force him to reveal the true value of your land (or, the secret of where he has hidden his gold, but not both). Or you could just look at your tax assessment. But don't use the exact number on the assessment, because most likely the "value" of your property according to the tax assessor isn't the same as what you paid for it. Usually this is a good thing! Nobody's out here trying to pay more property taxes. What you want to get from the assessment is the proportion of value of the land vs. the improvements. (Improvements are the buildings and everything else that isn't land.) Once you get the percentage of the total value of the property that is land, you can apply that to what you paid for the property.

How Depreciation Affects a Sale: Example Time

So okay, every time you depreciate a property, you're lowering its adjusted basis while adding to the pile of money you'll have to pay recaptured depreciation on when you sell. Here's what that looks like. Pretend Cersei bought a residential investment property in King's Landing. The purchase price was $1,000,000 and she paid $20,000 in closing costs. A tax assessment reveals that her land is worth $300,000. Her depreciable basis is: $1,000,000 + $20,000 - $300,000 = $720,000 Since it's a residential property, she divides $720,000 by 27.5 to get an annual depreciation allowance of $26,181.82. She rents her property to Olenna for five years, every year depreciating her property by $26,181.82 (and deducting that amount from her taxes). After five years, she decides to sell the property and gets $1,300,000 for it (King's Landing is rapidly gentrifying). Over the course of the five year "holding period," Cersei depreciated her property ($26,181.82 x 5 =) $130,909.10. Her depreciable basis is now ($720,000 - $130,909.10 =) $589,090.90. Since it cost her $50,000 to sell the property, her realized gain is $1,250,000. Her capital gain is $1,250,000 - $589,090.90 = $660,909.10. She pays taxes on that at the capital gains tax rate associated with her income. She additionally pays depreciation recapture on that $130,909.10 at a tax rate of 25%: $32,727.28. That's some serious cashola, but you know what they say: A Lannister always pays their debts. 👑

Straight-Line Depreciation

Straight-line depreciation is an accounting method used to figure depreciation that allows the taxpayer to deduct the same amount every year of the asset's useful life. Another depreciation method, called the modified accelerated cost recovery system (MACRS) (pronounced like "makers") (just so you know) is how the IRS requires people with investment property to calculate their depreciation. MACRS is very similar to straight-line depreciation, so we'll use that for our examples (the differences involve picky things about when the property was placed in service, and are best left to the tax pros).

Recovery Periods for Depreciable Assets

The IRS has determined "recovery periods" for depreciable assets. Your asset will fully depreciate by the end of the recovery period. At the end of the recovery period, the depreciable basis of your property will be $0. The recovery period for residential income-producing property is 27.5 years. Residential investment property includes apartment buildings, vacation rentals rented out more than 14 days a year, rental homes, and any other property people rent to live in. The recovery period for commercial investment property is 39 years. Commercial investment property includes things like office buildings, shopping centers, industrial parks, and professional buildings. How did the IRS come up with these extremely specific cost recovery periods? Listen, you don't want to know.

A Quick Note About Improvements

The IRS makes a big deal about the difference between "improvements" and "repairs." Essentially, improvements increase your basis in the property, and must be depreciated. Repairs just fix stuff, and can be deducted in the year they're made. If you make an improvement before a property is placed in service, the cost of that improvement can be added to your depreciable basis. If you make an improvement after you start using the property, that improvement is depreciated separately, instead of as part of the property.

What Can't Depreciate?

The biggest thing in the non-depreciable category is land. Remember waayyyy back in Level 1 and Level 2 we talked about how the qualities of land are indestructibility and permanence? Land doesn't depreciate, because land doesn't have a determinable useful life, and it doesn't lose value over time. Like your Uncle Jimmy always says, "They're not makin' any more of it!" Other things that can't be depreciated include: Equipment used to build capital improvements Personal property, including clothes Property placed into service and disposed of in the same year Stocks and bonds Intangible property Pokémon

When Should You Start Depreciating?

There are three major events in investment property ownership: Acquisition, or when you buy it Holding period, or when you own it Quinceañera, or when it turns 15 Just kidding! Reversion, or when it reverts back to the natural state of an investment, cash (by selling it) Depreciation is something that happens during the holding period. It doesn't start at acquisition, however — it starts when the property is "placed in service." An investment property is "placed in service" when you start using it for its intended, income-producing purpose. So if you buy an apartment building and spend two months renovating it before the tenants move in, you start depreciating it when it's done being renovated. You stop depreciating either when the property is fully depreciated (so after 27.5 or 39 years), or when it is retired from service (sold or converted to non-income producing property). Retirement parties for buildings are not tax-deductible, but would be adorable. 🎉

What Is Doing All This Depreciatin' Anyway?

There are three things that cause property to depreciate. Physical deterioration is stuff getting old and breaking. It's a gradual process — a roof damaged in a hailstorm is not physical deterioration, but a roof that wears out over time is. It's considered "curable" because things like damaged roofs can be repaired or replaced. In an investment property, physical deterioration becomes "incurable" when the cost of fixing it is higher than the value of having it fixed. In that case, just throw it right in the trash. 🚮 Functional obsolescence is when something loses value because it becomes outdated. It could be an aesthetic issue, like ugly pink bathroom tile, or an engineering issue, like an older house not having enough electrical capacity for modern appliances. It can be curable or incurable, depending on the cost of fixing it. External obsolescence is a loss of value from factors external to the property, like a change in zoning or a highway being cut through a neighborhood.

Depreciable Basis: It's the Basis for Your Depreciation!

To figure out how much you're going to depreciate over either 27.5 or 39 years, you need to figure out your depreciable basis. Remember before when we were talking about adjusted bases and eligible bases? Well, it's like that. Your depreciable basis is the purchase price of the property, plus the cost of acquiring it (expenses like broker fees, appraisal fees, title insurance, and other closing costs), plus any improvements you made to it before putting it in service, minus the value of the land. This diagram illustrates the different components of a property's value that make up the adjusted and depreciable bases. Notice that the depreciable basis contains all of the same components of value as the adjusted basis, minus the value of the land. If you remember what we talked about earlier, Mustafa, the land is taken out because it is not depreciable. Land is permanent and won't fall apart if you don't take care of it, but that fancy house on the land will fall apart someday if it is not maintained.

Don't Worry, the IRS Will Get Theirs: Recaptured Depreciation

You might not appreciate it, but all those sweet depreciation deductions will come back to haunt you when you sell your property, thanks to something called recaptured depreciation. Recaptured depreciation is the tax owed at the time of sale on depreciation taken during an asset's holding period. That tax rate is a healthy 25%, and you have to pay it whether or not you ever claimed a tax deduction for depreciation. Gather ye tax deductions while ye may!