The Depreciation Allowance: A Powerful Tax Benefit for Real Estate Investors
The allowance for depreciation is a significant tax deduction benefit provided by the IRS to real estate investors because it allows them to write off a "paper loss" during each year of ownership without spending any money out of pocket.
This is in contrast to other tax deductions, such as mortgage interest, which require the investor to pay out the interest in order to claim it on their taxes. With the depreciation allowance, no money is exchanged and the investor simply declares the deduction on their IRS form 4562.
The depreciation concept is based on the understanding that all physical structures associated with the property have a limited lifespan and will eventually become outdated or deteriorate.
The IRS, therefore, concludes that the owner of a property suffers a financial loss by owning the property and grants them the benefit of recovering this cost through their income taxes. And as a result, real estate investors can legally deduct an annual amount for depreciation as cost recovery from the cash flow generated by the asset during the past year of ownership, thus lowering their income tax liability for that year.
To determine the depreciation allowance, the tax code classifies all investment real estate into one of two categories and assigns a prescribed useful life to each.
- The first category is residential properties, which are rental properties that derive the majority of their income from dwelling units such as single-family homes, multi-family homes, apartments, and condos. These properties have a useful life of 27.5 years.
- The second category is non-residential properties, which are rental properties that derive their income from non-residential sources such as offices, retail space, strip centers, and industrial buildings. These properties, commonly referred to as commercial real estate, have a useful life of 39 years.
For example, let's say you purchased a duplex 13 months ago for $500,000, of which $100,000 is the designated value of the land.
To calculate your annual depreciation allowance, you would first determine the depreciable basis by subtracting the value of the land from the original value of the property:
$500,000 - $100,000 = $400,000.
Next, you would determine the useful life based on the property type. In this case, since the majority of the income is derived from dwelling units, this is a residential property with a useful life of 27.5 years.
Finally, you would divide the depreciable basis by the useful life to determine the annual depreciation allowance:
$400,000 ÷ 27.5 = $14,545.
= Annual Depreciation Allowance
- A Depreciable Basis is the original value of the rental property less the value of the land. Original Value - Land Value = Depreciable Basis
- Useful Life is either 27.5 years (property classified as residential) or 39.0 years (property classified as non-residential).
Rule of Thumb
1. It's important to note that the depreciation allowance is only applicable to the depreciable basis of the property, which is the original value of the property minus the value of the land (the value of the land is not included in the calculation because it is not considered to depreciate over time).
2. In addition to the useful life of the property, there are other factors that may affect the calculation of the depreciation allowance. For example, the method of depreciation used, the type of property, and any capitalized costs of acquisition or improvements made to the property.
3. The depreciation allowance is only available for investment properties and cannot be claimed for personal use properties. This means that if you own a property that you use as a personal residence, you are not eligible to claim the allowance. However, if you rent out a portion of your personal residence and derive income from it, you may be able to claim a partial allowance.
4. Finally, it's important to understand that the depreciation allowance is not a one-time benefit. It is a recurring benefit that can be claimed each year of ownership as long as the property continues to generate income. This means that real estate investors can potentially claim the allowance for the entire useful life of the property.
This is just a general overview of the concept of depreciation allowance and there may be other factors to consider when calculating the allowance. So always consult a qualified tax professional before making any real estate investment decisions.
So You Know
Depreciation Allowance is included in these ProAPOD solutions: