Tax deductions for homeowners
December 6, 2024
Tax Offset benefits – Real Estate Professionals – REPS
December 11, 2024The information provided herein is for general informational purposes only and should not be relied upon as legal or regulatory advice. For accurate and comprehensive details, please consult a qualified professional or contact the appropriate government organization to obtain official guidance.
Depreciation is a cornerstone of real estate investment strategy, providing a powerful tax benefit to property owners. It allows investors to recover the cost of income-producing properties over time by deducting a portion of the property’s value each year. We discuss here both on how it may you, available methods and how it affects capital gains. Deprecation is an essential tool for optimizing tax savings.
Primary methods of depreciation for investment properties
straight-line depreciation
Straight-line depreciation is the simplest and most commonly used method. Here, the property’s depreciable basis (total cost minus the land value) is divided evenly over the useful life of the asset.
How It Works:
- County tax records often list separate assessed values for the land and the structure (improvements). These values can be used to allocate the purchase price of the property into land (non-depreciable) and building (depreciable).
- While county tax records are a common starting point, they might not always reflect the true market value
Example:
- Residential Property Purchase Price: $500,000
- Land Value: $100,000
- Depreciable Basis: $400,000
- Useful Life 27.5 residential (39 yr Commercial)
The annual depreciation deduction would be:
Pros of Straight-Line Depreciation:
- Simplicity: Easy to calculate and comply with IRS rules.
- Predictability: Consistent annual deductions simplify tax planning.
Cons:
- Missed Opportunities: Straight-line depreciation does not accelerate deductions, which may lead to higher tax liability in the early years of ownership.
- Potential Recapture Tax : Depreciation recapture for real estate is usually taxed at a maximum rate of 25%, which may often be lower than ordinary income tax rates but higher than long-term capital gains rates (typically 15-20%).
cost segregation
Cost segregation is a more advanced strategy that accelerates depreciation by breaking the property into different components with shorter useful lives. Certain parts of a building, like fixtures, flooring, and electrical systems, can qualify for depreciation over 5, 7, or 15 years instead of 27.5 or 39 years.
How It Works:
- A cost segregation study is conducted by engineers and tax professionals to identify and reclassify assets.
- Once reclassified, the components are depreciated according to their assigned shorter lives.
Example:
Using the same $400,000 depreciable basis:
- $100,000 (structural components, 27.5 years)
- $150,000 (fixtures, 7 years)
- $150,000 (land improvements, 15 years)
The accelerated deductions could provide significantly higher tax benefits in the first years of ownership.
Pros of Cost Segregation:
- Accelerated Cash Flow: Larger early deductions lower taxable income, freeing up capital for reinvestment.
- Maximized ROI: A smart strategy for high-income investors seeking immediate tax relief.
Cons:
- Upfront Cost: Cost segregation studies can be expensive, often starting from $3,000+ depending on the property size.
- Complexity: Requires detailed documentation and expert analysis to comply with IRS regulations.
- Potential Recapture Tax: When selling the property, accelerated depreciation may lead to higher recapture taxes. (Section 1245 and 1250).
Choosing the Right Method
The choice between straight-line depreciation and cost segregation depends on the investor's goals, financial situation, and investment horizon.
- Straight-Line Depreciation is ideal for smaller properties, investors in lower tax brackets, or those seeking simplicity.
- Cost Segregation is best for larger properties or portfolios, especially for high-net-worth investors looking to maximize short-term cash flow and tax savings.
Tax Planning Considerations
- Bonus Depreciation: Check for the current tax laws, certain assets identified through cost segregation may qualify for bonus depreciation, allowing for immediate full expensing in the first year.
- Recapture Strategy: Depreciation recapture may offset some benefits of cost segregation upon sale. Investors can mitigate this by reinvesting proceeds into another property using a 1031 exchange.
- Change of strategy: A cost segregation study can be initiated in any year, even if you have previously been using the straight-line depreciation method without needing to amend the previous returns and possibly capture missed depreciation. Ref : form 3115
Conclusion
Both straight-line depreciation and cost segregation offer unique advantages to real estate investors. By understanding these methods, investors can align their depreciation strategy with their broader financial goals. Consulting with a tax professional or CPA is crucial to ensure compliance and to make the most of the tax benefits available. For real estate investors, depreciation isn’t just a tax rule—it’s a strategic tool for building wealth.
Depreciation Capture Tax (RE)
- Recapture is Only on the Depreciated Amount:
If no depreciation was claimed, there is no recapture; however, the IRS assumes you took the allowable depreciation.
Ordinary Income vs. Capital Gains
Income is considered ordinary when ownership is less than on year. Its considered Capital gains when it is greater than one year.
Depreciation Recapture Tax is one of the highest tax rates associated with the sale of real estate, a depreciable asset. Depreciation Recapture tax is a minimum of 25% across the board, only second to real estate owned less than one year, taxed as ordinary income which could be as high as 37% depending on your tax slabs.
1031 Exchange
A 1031 exchange allows for the postponement of both depreciation recapture tax and capital gains tax when selling an investment property, provided the proceeds are reinvested into a like-kind property. We will share more on a separate article
Recapture - straight line
- Straight sum up of the depreciation deductions taken
- For straight-line depreciation on real estate (Section 1250 property), the recapture of depreciation is generally taxed at a maximum rate of 25%. This is referred to as "Unrecaptured Section 1250 Gain."
Recapture - cost segregation
- Needs expert accounting and professionals for recapture calculations.
- Allocate Sale Proceeds: Allocate a portion of the sale price to each asset class. This determines how much of the accelerated depreciation is subject to recapture.
The recapture of depreciation for cost-segregated real estate is generally taxed in three distinct categories or "buckets":
Bucket 1- Section 1245 Personal Property
This category applies to the depreciation recapture on personal property components identified through cost segregation. These items are typically depreciated over shorter periods (5, 7, or 15 years) and include things like carpeting, certain fixtures, and specialized systems.
- Taxed at ordinary income tax rates
- No maximum rate cap
Bucket 2 - Section 1250 Recapture
This applies to real property that was depreciated using an accelerated method faster than straight-line depreciation. These may be 15 yr land improvements .
- Basically; its depreciation taken in excess of straight-line depreciation
- Taxed at ordinary income tax rates
- Rarely applicable to modern real estate transactions
Bucket 3 - Unrecaptured Section 1250 Gain
This category applies to the recapture of straight-line depreciation taken on the real property components of the building.
- Taxed at a maximum rate of 25%
- Applies to the lesser of the actual gain or the amount of depreciation taken
The use of cost segregation can significantly impact the tax treatment upon sale, as it reclassifies a portion of real estate as personal property. This reclassification results in more gain being taxed under Section 1245 at ordinary income rates, rather than benefiting from the 25% cap on unrecaptured Section 1250 gain[1][4]. Hence, proper analysis is needed to strategise on 1031 exchanges and other benefits by postponement of taxes.
Citations:
[1] https://www.reacpa.com/insight/depreciation-recapture-paying-the-piper-when-a-depreciated-property-is-sold/
[2] https://www.investopedia.com/terms/s/section1245.asp
[3] https://fincent.com/glossary/unrecaptured-section-1250-gains
[4] https://www.lumpkinagency.com/depreciation-recapture
[5] https://www.freshbooks.com/glossary/tax/section-1245
[6] https://www.reddit.com/r/tax/comments/1d63194/im_confused_as_to_why_unrecaptured_1250_gain_is/
[7] https://www.reddit.com/r/tax/comments/1gdsln6/depreciation_recapture_with_cost_segregation/
[8] https://turbotax.intuit.com/tax-tips/rental-property/depreciation-recapture-definition-calculation-and-examples/c5H96UGw8
[9] https://www.freshbooks.com/glossary/tax/unrecaptured-section-1250-gain
[10] https://www.straightupchicagoinvestor.com/blog/the-effect-of-cost-segregation-on-recapture
