So what is the #1 tax write-off for real estate investors?
No, it’s not repairs, maintenance, or real estate taxes.
And it’s definitely not insurance or management fees.
So what is it?
We’ll tell you.
The number 1 tax write-off for real estate investors is…..
And today. we’re going to break down depreciation, and how real estate investors can use it to save thousands of dollars in taxes.
So if you want to understand how depreciation works, what it is, and how it can greatly benefit you in real estate investing, then go ahead and keep on reading.
Today’s post is all about the #1 tax write-off for real estate investors and that is real estate depreciation.
Why This Write-off Exists in the First Place?
Real estate is one of the most tax-advantaged investment vehicles.
The federal and state governments structure tax laws to incentivize specific behaviors.
And, real estate ownership is one of the most important behaviors they want to incentivize taxpayers to do.
And this makes sense because the more homes bought in a certain area means more people are living in that area.
That would mean the economy in that area is being stimulated and more tax dollars are being collected.
The government wants you to invest in real estate because it means more tax revenue for them in the long run.
And the real estate depreciation write-off is an incentive that allows real estate investors to take advantage of some huge tax benefits.
What is Depreciation?
According to the IRS:
“Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property.”
Pretty much meaning that the IRS understands that yes, over time an asset or piece of property experiences some type of wear and tear, and the asset loses value because of it.
And after so many years, the asset effectively becomes worthless.
This cost is called depreciation.
For non-real estate assets, like a car for example, it truly does lose its value over time and will become a worthless asset. (Check out this post next if you want to learn how to write off your dream car.)
But the same is not true for real estate.
You see, depreciation assumes that an asset will lose its value. But as we all know, real estate actually tends to appreciate in value over time.
Yet, there’s this write-off for depreciation expense.
It’s a huge tax incentive for real estate investors and here is how it works.
The formula is the cost of the property divided by its useful life.
There are a few things to note here.
- The cost of the property should not include the land cost.
The land is not considered depreciable property. Land can’t be worn down or break apart.
Therefore, it is not included when determining depreciation expense.
- The IRS already defines what the useful life of real estate property is.
For residential property, like a house, the useful life is 27.5 years.
And for commercial property, it is 39 years.
It is assumed that a home that someone lives in would probably experience more wear and tear than a commercial office building.
This is why commercial real estate is deemed to have a longer useful life.
Read Estate Depreciation Example
Let’s see an example of the depreciation formula.
Let’s say you bought a residential property for $650,000.
The land cost is included in this amount and is worth $150,000.
This means the house itself is worth $500,000 (650-150).
You would then take $500,000 and divide it by the useful life of residential properties of 27.5 years to get an annual depreciation write-off of $18,182.
Mind you, you didn’t actually pay out in cash $18,182 but got the write-off for it.
And you get that write-off every single year for 27.5 years or until you sell the property. This is called straight line depreciation.
Assuming no other expenses, if this rental property gives you $25,000 in rental income for the year, you would normally have to pay tax on that $25,000.
And if your tax rate is 25%, it would mean $6,250 in taxes.
But with the depreciation write-off aka the number 1 write-off for real estate investors, you now only have to pay tax on $6,818.
This is derived from $25,000 in rental income minus $18,182 in depreciation expense.
Assuming the same tax rate of 25%, you would only have to pay $1,705 in taxes.
Compared to $6,250, that’s about $4,500 saved in taxes.
So as you can see, real estate depreciation acts as a tax shield and reduces your taxable income.
This means, you get to offset depreciation expense with the rental income you earn. This results in thousands of dollars in tax savings!
And you know what you could do with those savings?
That’s right, invest in more real estate and do the same thing with multiple properties.
Now, we know what you might be thinking. 27.5 years and definitely 39 years is a really long time to depreciate a piece of real estate.
You’re right, it absolutely is.
It would be even more beneficial to take more depreciation in the earlier years, especially if you only plan to keep the property for 5-7 years, right?
How to Accelerate Depreciation
Well, we have another strategy you could take advantage of as a real estate investor if you want to accelerate or speed up your depreciation deduction.
This strategy is for our hard-core real estate tycoons who are really looking to use the depreciation write-off to their full advantage.
And it is called a cost segregation study.
So up until this point, we’ve talked about depreciating the entire property over its useful life.
With cost segregation, you can take bits and pieces of the property, like the roof or cabinets, and depreciate the cost of those items over a shorter period of time.
This would allow you to take more depreciation write-offs in earlier years.
In order to do this, you would need to hire a team of CPAs who are qualified to do a cost segregation study.
You cannot do a cost segregation study yourself. Only qualified professionals can do it.
And what they would do is identify the property-related costs that can be depreciated over 5,7, or 15 years. That is opposed to the traditional 27.5 or 39 years.
The costs to have one of these done will cost you but likely will pay for itself by allowing you to accelerate depreciation on your property.
Now there is something you should be aware of as it relates to real estate depreciation.
And that is depreciation recapture.
So when you take depreciation expense as a deduction every year, you are reducing your basis in the property.
In other words, you are reducing the implied cost of the property.
If you paid $500,000 for the property and depreciated it for 1 year, your new basis or cost of the property is $481,818 (500,000 – 18,182 in depreciation).
The true value of the property is obviously not going down.
But for tax purposes, it technically is.
So what does all of this mean?
Excluding the land component here for simplicity.
If you sell the property after a year for say, $700,000, you will have to pay tax on the gain which is the difference between the sales price ($700,000) and your basis ($481,818) or $218,182.
As opposed to paying tax on a gain of $200,000 ($700,000 minus $500,000 purchase price).
This is called depreciation recapture.
This only occurs when you sell the property and have been taking depreciation on it.
You can avoid depreciation recapture altogether through a 1031 exchange.
A 1031 exchange is a swap of one investment property for another that allows capital gains taxes to be deferred and paid at a later time.
So once you sell one property for a gain, you buy another property within a certain time period and defer paying taxes on the gain earned for the first property.
That’s all we have for today’s post.
We hope you enjoyed and learned something new about real estate and how you can take advantage of depreciation to lower your taxes as a real estate investor.
Again, don’t hesitate to contact us to help you with saving more of your taxes.