Let’s face it, people become rich through real estate. Historically real estate goes up making people wealthier, but there’s more to it than that. We’ve all heard that real estate has tax advantage but aren’t sure what they are. I’m here to tell you, one of the ways the rich become wealthy through real estate is through depreciation. Depreciation allows real estate investors to get big deductions and at the same time keep more of their money. I’m going to teach you what real estate depreciation is and how it’s a magic bullet that keeps your money away from the IRS.
What is Depreciation?
Before I can teach you how real estate depreciation helps you pay less tax, I have to explain what depreciation is.
Simply put, depreciation is when the value of something you buy declines over time (think of it like “wear and tear.”) The IRS knows this, so when you buy a business asset that lasts longer than 1 year (such as a car, business equipment, or real estate) the IRS won’t let you deduct it all at once. The IRS makes you put it on the balance sheet of your business as an asset and deduct a little bit every year. That yearly deduction is called depreciation.
Here are some common examples you can relate to: if you’ve ever bought a brand-new car, one thing you’ve heard is that the value of the car drops the moment you drive it off lot. That means that the value has “depreciated.” Let’s say you buy a new iMac computer from the Apple store. After 5 or so years, you need a new one, why? Because it’s now old and worn down. Your computer has depreciated.
Depreciation Example
Here’s an example to make it stick. As I mentioned earlier, if the business asset has a useful life great than 1 year, it gets deducted over multiple years. Let’s say you purchased a piece of equipment for $50,000, and the IRS won’t let you deduct it all at once. They tell you that you must deduct it over 5 years straight-line (the same amount every year). So, you would depreciate it by $10,000 per year for the next 5 years.
| Year | Yearly Depreciation Deduction | Accumulated Depreciation (all years) |
|---|
| Year 1 | $10,000 | $10,000 |
| Year 2 | $10,000 | $20,000 |
| Year 3 | $10,000 | $30,000 |
| Year 4 | $10,000 | $40,000 |
| Year 5 | $10,000 | $50,000 |
| Totals | $50,000 | $50,000 |
We all inherently understand that things get old and run down, but what does that mean for your real estate investment & keeping money away from the IRS?
How Depreciation works with Real Estate?
When you buy a real estate investment (such as a rental), the IRS allows you to depreciate the cost of your building (but not the land). This allows you a big deduction, and this is how the rich keep their money from the IRS. Here is an example:
You buy a rental for $250,000. You collect $2,000 a month rent. Your taxes, mortgage interest, and insurance are $1,200 a month. That means you make $800 a month profit ($2,000 rental income less $1,200 expenses). You have cash flow of $9,600 a year ($800 x 12 months). You think you would have to pay tax on the net profit of $9,600, but you’d be wrong. Because of the real estate depreciation magic bullet you get an additional deduction.
First, it’s important to know that every rental is broken down into (at least) two components, land and the building. We’ve decided to use the following amounts for our example:
- Land – $30,000
- Building – $220,000
In our example, the property is a residential rental, so the IRS makes you depreciate the cost of the building over 27.5 years. Your depreciation deduction is $8,000 (calculated as $220,000 divided by 27.5 years. )
Even though you get to keep the entire $9,600, because of depreciation you only pay tax on $1,600 ($9,600 cashflow – $8,000 depreciation.)
| Category | Yearly Amounts | Monthly Amounts |
| Income | $24,000 | $2,000 x 12 |
| Mortgage Interest, Property Taxes, & Insurance | <$14,400> | <$1,200> x 12 |
| Cashflow (profit before depreciation) | $9,600 | Cashflow |
| Building Depreciation | <$8,000> | $220,000 divided by 27.5 years |
| Profit reported to IRS | $1,600 | You keep $9,600, but only pay tax on $1,600 |
This is how the rich make money in real estate and pay the IRS less.
Why is Land not Depreciated?
The IRS decided a long time ago that land is not depreciable because all building components have wear and tear, and land doesn’t. You’ll eventually have to change the roof, install new dry walls, put in new carpet, etc. However, land just sits there, you can build on top of it, but not change it.
IRS Trap
IRS Trap: I get asked this question all the time, “If I own a condo, do I still have to put a portion of my real estate investment to land?” The answer is yes.
That’s because when you own a condo you are part of the HOA (Homeowner’s Association) and you indirectly own the land of the common area. The IRS loves to get people when they don’t allot land to their condos or townhomes. Don’t fall for this trap.
What Percentage should I put to Land?
This is a huge debate among CPAs and tax preparers. Remember, you want the least amount to land, and more to the building so you can get a better deduction. We recommend finding how the local county assesses land vs building in your area (it’s different in every county).
From my experience, if the property is not on farmland, I normally see between 10% – 20% as value to land.
What is the Depreciable Life of Real Estate?
Depending on the type of real estate investment you have, the IRS has different rules for the depreciable life. Remember, you want a lower life, because that means you can depreciate more sooner. If your real estate investment has a “dwelling unit,” then you get a shorter life (according to the IRS’ a “dwelling unit” generally means a house or apartment used to provide living accommodations in a building or structure.)
Here’s a quick list of real estate investment property and what the IRS says is there depreciable life
- Residential rentals 27.5 years (also known as dwelling units)
- Apartment complexes 27.5 (because it’s a series of dwelling units)
- Commercial buildings 39 years
- Industrial Warehouses 39 years
- Home office 39 years
- Foreign real estate rentals 40 years
- Land Investment – Zero
- Airbnb – it depends.
Airbnbs are more complicated because if you meet certain tests, not only is the depreciation over 39 years, but you will also be subject to an extra 15.3% in self-employment tax. It’s a lot to go into, and out of the scope of this article, so I wrote a different article on it here.
What is Accelerated Depreciation?
Two very important topics in real estate investing are Cost Segregation and Accelerated Depreciation. They work hand-in-hand. So I’m going to start with Accelerated Deprecation.
Accelerated Depreciation is when you can speed up the depreciation and not wait to get the deduction. There are two special types of Accelerated Depreciation – Bonus Depreciation and Sec 179 Deduction. Nowadays people talk about Bonus Depreciation, since it allows you to depreciate 100% of the cost of the business asset. However, there’s a catch, you can only use assets that have a useful life of less than 20 years for bonus depreciation. Using Bonus Depreciation, you can deduct expenses like appliances, carpet, leasehold improvements, you can depreciate in one year.
Here is a bonus depreciation chart so you know how much of your expense you can deduct per year:
| Tax Year | Bonus Depreciation % |
|---|
| 2021 | 100% |
| 2022 | 100% |
| 2023 | 80% |
| 2024 | 60% |
| 2025 | 40% |
| 2026 | 20% |
| 2027 | No more bonus depreciation |
Even thought Bonus Depreciation is slated to end after 2026, don’t worry. Congress has extended Bonus Depreciation many times in the past, so it’s likely that they will also extend it in the future. Also, for the years 2023 through 2026, since you don’t get 100% of the depreciation deduction, you can make a Section 179 election, and depreciate it all anyway.
Now let’s talk about how Cost Segregation works with Accelerated Depreciation
Cost Segregation
Cost Segregation is when you segregate (split up) your investment property into difference components that have lower depreciation lives, so you can deduct more of it sooner. Smaller depreciation lives allow you to save more money faster.
There are many different parts to real estate rentals. Common ones are:
- Roof
- Windows
- Carpets
- Flooring
- Electrical
- Land Improvements
- HVAC
- Structure
If you break them up into smaller components that have 5-year, 7-year, and 15-year asset classes, you will get a bigger deduction.
Let’s take our example from above, except we had a cost segregation study done on it and the engineers came back with the following:
- Land – $30,000
- Building – $165,000
- 15-year property – $35,000
- 7-year property – $15,000
- 5-year property – $5,000
Guess what, in 2022 the 5-year, 7-year, & 15 year property are all depreciable immediately because of Bonus Depreciation. Even though the building is depreciable over 27.5, we still get $6,000 depreciation for that ($165,000 / 27.5). So, our total depreciation deduction is $61,000 ($6,000 building + 35,000 + $15,000 + $5,000.)
| Category | Yearly Amounts | Monthly Amounts |
| Income | $24,000 | $2,000 x 12 |
| Mortgage Interest, Property Taxes, & Insurance | <$14,400> | <$1,200> x 12 |
| Cashflow (profit before depreciation) | $9,600 | Cashflow |
| Building Depreciation | <$6,000> | $165,000 divided by 27.5 years |
| Bonus Depreciation | <$55,000> | $35K+$15K+$5K |
| Profit reported to IRS | <$54,400> | You keep $9,600, but only pay no tax |
Even though you now have a loss, and you won’t have to pay tax on the $9,600 of cashflow, there is another thing you will have to be aware of regarding your giant loss. That’s PAL (Passive Activity Loss). We will be covering that in a different article in the future.
Where can I get a Cost Segregation Study?
The truth is that Cost Segregation Studies are expensive. It’s usually big commercial real estate investments pay for them. And engineering firms, looking to cash in, will charge anywhere from $5,000 to $20,000 for one.
But what about the little guy that owns a small rental? Don’t worry, I’ve got your back.
First, there are a couple websites that will calculate them for you for a much smaller fee than what the big firms charge. They are:
KBKG – created Residential Cost Segregator. It currently costs $430 per unit.
DIY Cost Segregation – created by ELB Consulting, currently costs between $495 to $995 depending on if your property is a single-family home up to a 4-plex.
Your second option is do it yourself. That’s right, the IRS allow you to calculate a Cost Segregation yourself. However you would have to educate yourself on how engineers and appraisers come up with their Cost Segregations first. It’s easy to break out items like carpet and appliances, but it’s much more difficult to figure out what the electrical component is and allot the correct amount for the IRS. Be careful if you decide to go with this route and do it yourself, and make sure to check with your CPA first.
Conclusion
We didn’t tell you everything about real estate and tax strategies, but we told you about one of the most important ones.
There are other important tax strategies we are going to teach you about in the future. Such as Passive Activity Rules, and How to become a Real Estate Professional in the eyes of the IRS. Until then, remember that your tax situation is different from anyone else. So please make sure to consult with a CPA before making any investments so they guide you, tax-wise, regarding your particular situation.