Ask a Real Estate CPA – Should I Accelerate Depreciation for my Rental Properties?
One of the biggest benefits to operating a real estate business are the tremendous tax benefits. Real estate businesses and owners simply have more options available regarding when and how much gets paid in taxes. One of the more confusing options can be accelerated depreciation. Here are some of the more common questions and concerns we hear from real estate investors, owners, and operators:
1. Why would you want to accelerate depreciation on a rental property?
First let’s discuss what depreciation is and why it matters. As an asset ages, it becomes less and less valuable over time until the asset hits a minimum value, referred to as the “salvage value.” For commercial and multifamily assets, that minimum value occurs 30 years from purchase. This is important because the IRS allows a real estate investors to deduct that depreciation from total income over a period of 30 years, reducing an owner’s taxable income and overall tax bill.
The IRS wants the depreciation to be spread out over 27.5-40 years, effectively capping an owner’s deductible depreciation per year. Accelerating that depreciation schedule is effectively getting an advance on an asset’s total depreciation. This allows an owner to pull up to 80% of an asset’s total depreciation forward into a truncated series of deduction or, in some cases, a single deduction, The net benefit is a huge, one-time tax deduction. This is attractive to some owners as the deduction offsets other incomes and expenses, resulting in increased cashflow for each year the deduction is taken.
Some common scenarios where investors will accelerate depreciation are:
- Selling existing asset (or a portfolio) to purchase a new multifamily asset, exposes sale proceeds to capital gains taxation. Accelerating depreciation on the new property could offset taxes owed on the sale of the other assets.
- Purchasing a series of assets, or acquiring an asset in need of repositioning, may create a need for the increased first-year cashflow that accelerated depreciation offers.
2. What are the risks of accelerating depreciation on a rental property?
Accelerating depreciation compresses all the depreciation of a 30-year period into either a single deduction or a truncated series of deductions. The IRS’ assumption here is that an owner will hold the depreciated asset for the full 30 years. Pulling the depreciation deduction forward removes that deduction from the latter years of an asset’s lifetime. Essentially an owner is trading in steady, long-term depreciation for sizeable, short-term tax deductions, potentially reducing cashflow over time.
Another drawback to accelerated depreciation is recapture taxation. If the asset sells for a profit within that 30-year period, the IRS sees the sale profit as recaptured depreciation since the asset didn’t depreciate over the full 30 years as expected. In addition to the profit being taxed as income, the IRS will also take back, or recapture, a portion of the deducted depreciation. Recaptured depreciation taxes can be up to 25%, while capital gains can be taxed up to 20 %.
Last, while not a risk, investors need to budget for a cost segregation study when seeking to accelerate depreciation. Since certain aspects of an asset (e.g. HVAC) can be depreciated faster than others a cost segregation study determines the total amount of depreciation that can be deducted and over what time frames those deductions can occur. In some cases, cost segregation studies can run anywhere from $10,000 - $25,000 or more.
3. What impact does accelerated depreciation have on your tax return/tax liability?
Since accelerating depreciation is effectively seeking an advance on an asset’s total depreciation, getting a large depreciation deduction can dramatically reduce your tax bill for a given period. Without accelerating depreciation, investors would only get 1/30th of the total depreciation deduction. That’s $33K on a $1MM asset. So if an investor made $800K, $33K doesn’t offset much income. Accelerating depreciation means that up 80% of that $1MM asset may be deductible at once, completely offsetting the investor’s $800K of taxable income and effectively erasing their tax liability for the year.
4. What is the best depreciation method in real estate? Why?
Like most things, the “best” depreciation method is subjective and depends on your business’ goals and timelines. Before picking the “best” method, however, it’s crucial to determine the property’s depreciation eligibility. It’s always a good idea to consult IRS.gov for an up-to-date list, but some criteria include that you must own the property and that the property must be used for income-generating purposes (e.g. leasing).
Two of the most popular depreciation methods are straight-line and accelerated. Straight-line is where the overall depreciable value of the asset is chopped up evenly over 27.5 years. Accelerated is a catchall term for multiple different methods including double declining balance. The “best” of these methods is the one that aligns depreciation deductions with cash flow projections and business goals.
5. How does depreciation recapture work when you sell a property?
When the sale of a depreciated asset generates a profit, that profit is subject to both capital gains tax and taxes on depreciation. The IRS taxes the non-depreciation-related gains as capital gains, capped at 20% for 2023. The depreciation-related portion then gets taxed at the higher rate of 25% for 2023.
Let’s say a rental property sold for a profit of $100,000. If $60,000 worth of depreciation had been deducted during the seller’s ownership, the IRS would tax the $60,000 at up to 25%. The remaining $40K would be taxed at the capital gains rate of up to $20%. If the property sold for a loss, only the depreciated portion would be taxed.
Owners do have the option of deferring both capital gains taxes and recapture taxation via a 1031 or like-kind exchange.
6. What advice would you give to someone considering using an accelerated depreciation technique on their rental property?
Think about the long-term plan for the property, find a trustworthy real estate CPA, and choose a cost segregation professional. Long-term holds can make accelerated depreciation a powerful tool for reducing tax liabilities. These benefits can extend to all personal income, not just the real estate-related portions.
Short-and mid-term holds make things more complex as the IRS will be sure to tax sale proceeds at a higher rate when accelerated depreciation is chosen. Accelerated depreciation is a strategic decision and one that benefits from a seasoned, real estate CPA’s guidance.
Accelerated depreciation should be thought of as a tool to achieve a greater goal. A long-term view of asset holdings and a lengthy acquisitions / dispositions strategy helps identify when accelerating depreciation may or may not be a helpful option. Tax benefits from accelerating depreciation can be significant, but it’s important to note that accelerating depreciation is more about timing than it is about tax savings. Ultimately, the taxes will still be owed and it’s up to the real estate investors when they want to pay those taxes.
Critically, accelerated depreciation and bonus depreciation start with a, potentially expensive, cost segregation study. And if bonus depreciation is being considered, keep an eye on federal regulations. As of 2023, bonus depreciation is capped at 80%. This number will step down over the coming years.
As with any serious investment, consulting an expert increases surety and confidence tools such as accelerated depreciation. A real estate CPA or fractional CFO can provide seasoned advice and guidance for real estate investors and owners looking to optimize their tax position.
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