Accelerated depreciation can be a powerful strategy to increase the profitability of your assets in the early years.
Depreciation in real estate refers to the allowable deduction landlords can take each year to compensate for the gradual decrease in the value of a property over time due to factors like wear and tear, aging, and obsolescence.
Accelerated depreciation is a method that allows property owners to deduct a larger portion of the property's value as an expense in the earlier years of ownership.
Accelerated depreciation is a strategy that allows for a greater depreciation value in the earlier years of an asset’s life. What this means in regards to real estate is that you can depreciate fixtures and moveable assets within the property (eg. appliances) faster than the useful life of the property. This allows you to deduct more of the total depreciation in the first 5-7 years of buying a property.
To claim depreciation and track your accelerated depreciation over the years you will likely want a quality rental property accounting software that will enable you to keep accurate records with ease.
There are several methods of accelerated depreciation which include double-declining balance (DDB), where there will be higher depreciation expenses in the first few years and lower expenses as the asset ages. As well as the straight-line depreciation method, which spreads the cost evenly over the life of an asset.
For real estate, you will need to conduct a cost segregation study to determine the value of the assets that you want to depreciate independently of the overall value of the property.
Anything that has a shorter “useful life” than the rest of the structure can be depreciated faster than the building itself. This allows you to get a better tax write-off initially. You can break out pretty much anything that has a shorter life span.
For example, the furnace, light fixtures, stoves, etc. And then depreciate the full value of these assets over their useful lives – normally 5-7 years – rather than over the useful life of the property which is 27.5 years for residential property or 39 years for commercial.
It’s a double-edged sword, however, as, after you accelerate this depreciation, you will be left with a lower annual depreciation write-off. Plus when you sell the property you will need to pay taxes on these depreciation amounts via depreciation recapture.
There are both pros and cons to using an accelerated depreciation strategy. Generally, it’s considered a more beneficial for short-term investment strategies. It can also benefit real estate investors who are looking for increased cash flow in the early years to help them scale their portfolios.
However, for people with a longer-term investment strategy, the decrease in allowable depreciation in later years could be a detriment. As always when it comes to issues like this it is recommended to talk it through with your property tax accountant or CPA to see if this is the right strategy for you and your long-term financial goals.
The double-declining balance (DDB) method is an accelerated depreciation method. After taking the reciprocal of the useful life of the asset and doubling it, this rate is applied to the depreciable base—also known as the book value, for the remainder of the asset’s expected life.
For example, an asset with a useful life of five years would have a reciprocal value of 1/5 or 20%. Double the rate, or 40%, is applied to the asset’s current book value for depreciation. Although the rate remains constant, the dollar value will decrease over time because the rate is multiplied by a smaller depreciable base for each period.
The sum-of-the-years’-digits (SYD) method also allows for accelerated depreciation. To start, combine all the digits of the expected life of the asset. For example, an asset with a five-year life would have a base of the sum-of-the-digits one through five, or 1 + 2 + 3 + 4 + 5 = 15.
In the first depreciation year, 5/15 of the depreciable base would be depreciated. In the second year, only 4/15 of the depreciable base would be depreciated. This continues until year five depreciates the remaining 1/15 of the base.
Generally, when you buy a property you can depreciate it over the useful lifetime eg. 27.5 years for residential and 39 years for commercial properties. However, you may be able to accelerate the depreciation of parts of the value of this property.
To do this you would need to get a cost segregation study done which would enable you to break out the value of fixtures and fittings that are not deemed as integral or structural parts of the building (such as the furnace). These fixtures will generally have a shorter life span than the property itself and can be depreciated each of those broken out assets separately.
This allows you to increase the deductible amount in the first years of the property’s life allowing you to maximize cash flow. However, the method of cost-segregation can be quite complicated and will require you to have a separate depreciation schedule for each of these assets.
Cost segregation allows landlords to accelerate depreciation because both the improvements made to land and any personal property or moveable fixtures, as mentioned above, have shorter depreciation periods (as determined by the IRS) than the property itself, usually between five and seven years.
Accelerated depreciation does not change the overall amount of depreciation you will be able to claim but it gives you a larger chunk of this depreciable value in the first few years of owning the property. If you want to know more about accelerated depreciation for your own properties it’s recommended to consult with a licensed professional accounting firm to determine if a cost segregation study and accelerated depreciation will save you money.
100% bonus depreciation and Section 179 deductions allow you to take your depreciation deduction all at once instead of waiting some predetermined amount of time. Up until 2023, the bonus depreciation is 100%.
In 2023, it will begin decreasing 20% every year until 2027, at which point it will no longer exist. Both deductions only apply to specific improvements and purchases. Depreciation recapture applies to 100% bonus depreciation.
Bonus depreciation works by allowing you to deduct a percentage of your improvement’s cost basis at the time of its purchase. Or if you do a cost segregation study some of the fixtures or elements of the property will qualify for 100% depreciation and can be depreciated in a single year. It only applies to improvements that have a useful life of 20 years or less (useful life being the amount of time the IRS has determined an item can be used as part of a business’s operation).
1. It reduces initial costs.
Accelerated depreciation allows you to decrease your set-up costs by giving you greater depreciation tax deductions in the first years of owning your property. This can be incredibly valuable in creating a cash-flowing business early on and help establish profitability and some financial windfall. Also, with more money to spare in these first few years, you’ll be able to reinvest in your rental business and potentially scale faster.
2. It allows you to take higher deductions upfront.
By maximizing deductions upfront with accelerated depreciation you can reduce your end-of-year tax bill significantly which could actually help you save money, in the long run, depending on your investment and growth strategies.
3. It helps with tax deferrals.
This process creates increased depreciation in the early years of owning your rental property. These depreciations will be reclaimed in part by the IRS when you eventually sell the property. However, you can defer this depreciation recapture indefinitely with a 1031 exchange. It is important to note that this will be reclaimed one day and you could be in for a nasty surprise if you don’t plan for the eventual depreciation recapture – but this process does give you more time before you have to pay that full tax bill.
We have talked a lot already about depreciation recapture, so we thought it’d be a good idea to quickly explain what it is, how it works, and show an example.
Depreciation recapture is probably the main downside of depreciation and rears its ugly head upon the sale of a depreciated asset. The value of the depreciation you take over the life of your property in the eyes of the IRS is the value of the property actually decreasing. When you sell your property the value of the original asset is equal to the original purchase price minus the total depreciated amount.
This means, for example, if you bought a house for $250,000 and took $100,000 in depreciation, the IRS would view that property’s original value as $150,000 (original value minus the depreciated amount). If you then went on to sell the property for $300,000 the IRS would see the total taxable capital gains as $150,000, not $50,000.
Additionally, the capital gains associated with depreciation recapture are taxed as ordinary income with a maximum tax rate of 25% rather than the capital gains tax rates. As such, by accelerating depreciation you may owe more money through depreciation recapture when you sell the asset.
It’s a good idea to know about accelerated depreciation as it can be a powerful strategy to increase the profitability of your assets in the early years. For real estate investors having more cash in those early years can be a great way to scale their rental business and achieve their financial goals faster. As always, you will want to talk with a licensed property tax accountant or financial advisor before making any decisions. Accelerated depreciation and cost segregation can be complex and hard to track, especially when it comes to capital improvements, but under the right circumstances is a very useful tool.
All property has a useful life determined by the IRS of 27.5 years for residential property and 39 for commercial property. The IRS will assume you’ve taken your allowable depreciation even if you don’t so make sure to calculate and deduct the depreciation each year as you’ll be liable for the depreciation recapture either way.
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