Understanding Real Estate Tax Benefits: Depreciation, Accelerated Depreciation, Bonus Depreciation

The tax benefits of real estate have long been important to me. Back when I started my career as an emergency room physician, it was shocking to me just how much money would get taken out of my check each month. As I continued in that career, I started to feel the effects of burnout. The Mayo Clinic found that physicians are at a disproportionally high risk of burnout. That was me. I had health insurance, life insurance, malpractice insurance and disability insurance. But there was no insurance against burnout.

Fortunately, I was able to self-insure using real estate for stable streams of tax-advantaged passive income. It became important to me to learn all I could about the subject. I ultimately chose to leave medicine after 18 years in the emergency department. But I knew there were a lot of other doctors just like me, so I made it my mission to teach them about this asset class and the tax advantages inherent within it.

Real estate investing has a long history of being highly tax-advantaged. It provides a whole host of deductions that, when structured correctly, can help the investor defer taxes for years on the income they derive from their property.

Additionally, there are liquidity strategies that similarly defer taxation. For example, real estate investors can harvest lazy equity in their property via a refinance and not trigger a taxable event. Likewise, they can sell their property and execute a 1031 exchange, deferring taxes yet again.

Taxes can even be eliminated through a legacy transfer of wealth to one’s heirs. Upon the owner’s death, his or her investment property goes through a basis reset that eliminates taxes that would have been due.

These tax advantages are available to all investors regardless of whether they’re invested passively or actively. Underpinning most of these advantages is something called depreciation.

Understanding Depreciation

In the simplest of terms, depreciation is the reduction in value of an asset as it ages. To account for this, the IRS allows individuals to allocate the cost of an asset over its life expectancy.

A whole host of assets are eligible for depreciation, including investment real estate. The curious thing is that real estate typically appreciates in value over the long-term. Nevertheless, depreciation is allowed and historically the IRS has set the useful life of resident-occupied real estate as 27.5 years.

So how does that work?

Let’s look at an example. Pretend that you purchased a 25-unit apartment building for $3.5 million. In this example, the land is valued at $750,000. Land is not depreciable, but the remaining $2.75 million is. When you divide $2.75 million by 27.5 years, you get $100,000 per year of depreciation for the next 27.5 years.

Accelerated Depreciation

This is known as straight-line depreciation and it’s the basis for many of the tax advantages within real estate. Depreciation can be such a hefty benefit that some individuals look to frontload it and take as much depreciation as possible in the early years of ownership. This is called accelerated depreciation.

In order to do this, a cost segregation study has to be performed. In our previous example, a cost segregation specialist would analyze that 25-unit apartment building. The purpose of this is to identify the non-structural elements and land improvements and separate them from the structural elements.

The structural elements still get depreciated over the 27.5 years, but non-structural items like wall coverings, carpet, fixtures and others are reclassified as personal property. Personal property can be depreciated over a shorter period (typically five or seven years).

Land improvements like parking lots, landscaping, sidewalks, swimming pools, fencing, etc., get depreciated over 15 years. By doing a cost segregation study and reclassifying the personal property and land improvements within our 25-unit apartment example, we’ll obtain significantly more depreciation benefit in the early years of ownership.

Bonus Depreciation

In the right circumstance, frontloading depreciation can be highly beneficial. However, in the short-term, bonus depreciation has taken that accelerated benefit to new heights.

Unless you’re investing in new development, bonus depreciation likely isn’t on your radar. Historically, this benefit was only in the new development space. However, the Tax Cuts and Jobs Act of 2017 changed all of that.

For properties acquired after September 27, 2017, owners can take a 100% benefit in year one. The property doesn’t have to be new; it just has to be new to you. That means that all of the personal property and land improvement benefit no longer has to be spread over five, seven or 15 years. Instead, it can all be taken in year one.

That can equate to a massive windfall of depreciation in year one. But why would somebody want that?

There are millions of people who receive significant passive business income as reported on a K-1. For those people, bonus depreciation can provide a material benefit.

Take, for example, someone with $150,000 of K-1 passive activity gain from an unrelated business. In addition, this same person also has $70,000 of first-year bonus depreciation from a rental property. Instead of paying tax on $150,000, they can subtract the $70,000 of depreciation and only be taxed on $80,000 of income in that year. Depending on their tax bracket, they could see a material reduction in that year’s tax, potentially to the tune of tens of thousands of dollars.

Conclusion

Real estate investors have been benefiting from the substantial tax savings inherent in this asset class for decades. The Tax Cuts and Jobs Act of 2017 and its expansion of bonus depreciation have made these benefits significantly better.

With that said, as currently written, the bonus depreciation benefit will last through 2022 and then phase out 20% per year from 2023 through 2026. Unless renewed, it will be gone in 2027.

So if you have significant K-1 passive business income and want to pay less money in taxes, you might want to consider looking into real estate and the benefit of bonus depreciation.

This post first appeared on Forbes.com. To see the original, click here.