Depreciation and Bonus Depreciation are probably the most crucial things every aspiring real estate investor needs to learn if they want to successfully make the highest returns on their real estate investments.
But why? – You might ask.
Simply because if depreciation is not applied, a company’s financial statement could take a severe hit, showing smaller profits or larger losses for the year it made the acquisition.
Depreciation and Bonus Depreciation are hands down one of the best tax advantages to owning real estate for investment. To start this conversation, you need to know first what Depreciation is.
Depreciation 101
Depreciation is a method utilized by accountants, CPAs, and Tax Lawyers to determine how much of the costs for buying and improving the property can be deducted.
In other words, it represents how much of an asset’s value has been used up. In the case of real estate properties, this deduction is spread across several years, 27.5 for residential real estate and 39 years for commercial real estate. Those years represent the useful life of the property.
Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use. If not taken into account, it can greatly affect profits.
The requirements for depreciating property, according to the IRS, are:
- You must own the property. It doesn’t matter if you have a mortgage or another financing arrangement, as long as the property is titled in your name or your entity’s name.
- That property is income-producing or used in your business (like multifamily properties and assisted living facilities).
- Your property has a useful life, i.e, it loses its value from natural causes.
- This asset is expected to last for more than a year.
At this point, you should know that land can’t be depreciated, because it’s not used up. It is part of your property, yes, but not the depreciable part. Always keep that in mind.
How Are Deductions For Depreciation Evaluated?
You can start depreciating your property as soon they’re ready to be rented. Deductions are evaluated after your accounting professional considers 4 key elements at the end of the fiscal year:
- Determine the basis of the property. This is the cost per acquisition. The price you paid for the property.
- Separate the cost of the land and buildings. Remember that you can’t depreciate land, therefore, each part of the real estate has to be valued and separated
- Determine the basis in the house.
- Determine the adjusted basis. It’s a matter of adding and subtracting. You add the money spent on improvements, repairs, utilities, and certain legal fees that have a useful life of at least 1 year before the property was placed into service. Things that detract from the basis are insurance payments received as a result of damage or theft, casualty losses not covered by insurance that you took a deduction for, and grant money for an easement.
When all 4 elements are taken into account, your rental income is reduced by the Depreciation Expense on your Schedule E of your 1040 tax return. Thus, your income is offset or reduced by this deduction. Depending on your real estate holdings, the deduction for Depreciation could be hundreds of dollars or thousands. It adds up quickly and you will come to figure depreciation into your valuation of potential investments for real estate.
Bonus Depreciation
This is a game-changer in every sense of the word. Simply put, Bonus Depreciation allows you to take the entire cost of specific capital investments in one year. This reduces your federal income taxes in the year you place those assets into service.
But first, understand that Bonus Depreciation is not for the Real Estate itself, the land, and the structure. It only applies to Capital Assets with a life of fewer than 20 years.
So, what does this actually mean?
Let’s take something simple like an oven or other appliances. Bonus Depreciation allows you to take the entire cost of that asset in one year. So that $900.00 oven you just put into that house is now a 100% deduction. Moreover, you don’t have to buy a new oven. It just has to be new to you and you cannot obtain it from a related party.
As you can see, when you understand these concepts well and plan accordingly with your tax lawyer, you can take advantage of them to steadily build wealth. Paired with income-producing properties like multifamily complexes and assisted living facilities, you will definitely have the path carved out for you as long as you continue to care and improve your investments!
And remember! If you want to learn more about syndication, you can read our blog or subscribe to our newsletter! We frequently share information like the one in this article to help you learn more about passive investing, real estate, and our favorite asset class: Multifamily properties!