Depreciation Rules All Passive Investors Should Know
No one wants to pay for depreciating assets. While they are useful when operational, they also lose value over time. Fortunately, there are several tax deductions passive investors can take advantage of while owning their property(s). One of these is depreciation.
Depreciation is a decrease in the value of a fixed asset (property, equipment, etc.) due to natural wear and tear, age, or obsolescence. It’s a tax deduction available to passive investors. In other words, you can take a deduction for a portion of the value of your property that has been lost over time. This is calculated is by dividing the cost of the property by the number of years it is expected to be used.
Depreciation is an expense that must be deducted over time based on the expected life of an asset (such as a building), regardless of how much profit you’re making. That amount, which has been "used up" over time, should be recorded under an expense account called "Depreciation Expense." To record depreciation, you would debit this account and credit accumulated depreciation or a contra-asset account for the net decrease in the value of the building.
One reason some investors may not claim depreciation is that they are unaware of the available deductions. So before we explain the rules, let's dive into the nuances and varying types of depreciation.
Depreciation and Real Estate Investments
There are two types of depreciation: Modified Accelerated Cost Recovery System (MACRS) and Accelerated Depreciation Recovery (ADR). The MACRS is a set of guidelines set by the IRS for people with business or investment properties to use as they calculate their depreciation deduction. The ADR is a set of guidelines for people who own real estate that they use for personal purposes.
The most common type of depreciation for real estate investments is MACRS, which is based on the property's "useful life." This means that you can only claim a depreciation deduction on the property if it has a certain useful life, which is relative to its type. For example, your passive real estate investments may include buildings (for businesses) and dwelling units (for personal purposes). These two types of properties have different "useful lives," so they require depreciation calculations specific to their type.
Passive Investors Can Claim Depreciation
Depreciation is a deduction that allows passive investors to recover their original costs.
For example, if you bought an apartment building for $100,000 and it becomes worth $150,000 when you sell it, depreciation lets you claim the difference in your taxes.
Claiming Depreciation
Depreciation recapture is the process of owning a depreciable asset that gains value over time. This can come in handy during tax season because this increase in value must be declared as part of your taxable income.
The first rule is that depreciation must be taken in equal amounts each year. This is called the uniform capitalization rule. This means that if an investor buys a property for $100,000 they will depreciate it by $10,000 per year for 10 years.
The best way to understand this is through an example: Let's say you purchase a property for $100,000, and it is expected to last for 10 years. You can claim a depreciation deduction of $10,000 per year. However, if the property is sold for $110,000 after only 8 years of ownership, you will have to declare the recapture amount of $2,000 as taxable income.
Important Rules to Remember
To claim depreciation, the property must be used for business or investment purposes.
You cannot depreciate land. Only buildings and other structures attached to them qualify for this deduction.
The depreciation period of residential rental properties is 27.5 years, beginning on January 1st of year 4 after the property purchase date. This means that each year for the next 27.5 years, a percentage of the building value will be deducted as a depreciation expense to account for its decline in value related to age and wear and tear.
To take advantage of depreciation, you must be able to demonstrate that you are the owner of the property and are actively using it in a trade or business. Passive investors who don't meet this criterion can still claim depreciation expenses through a partnership, corporation, or LLC.
You can only claim depreciation for the years that the property is being used. For example, if you purchase a property in year 1 and sell it in year 5, you can only claim depreciation for the 5 years that it was owned, not the full 10 years.
The amount claimed cannot be more than the actual amount of depreciation taken.
Depreciation must stop at the end of an asset's useful life, which often coincides with its expected salvage value. This means that an investor cannot continue to depreciate a property after it has been replaced or sold.
With depreciation deductions lowering taxable income on investments, many people are eligible to deduct more of their passive income from taxes using depreciation deductions.
Depreciation is a non-cash expense, meaning that you do not have to spend actual cash to be eligible for a deduction relative to this expenditure. In general, these types of expenses are deducted in the year when they occur and not in the year when you spend the cash.
Maximize Your Deductions by Investing in Real Estate
There are several things you can do to maximize your depreciation deduction:
Increase basis in your real estate property by making qualified property improvements. In general, if an improvement is not a "qualified" property improvement, then you cannot claim a depreciation deduction for that cost. However, there are some exceptions to this rule and your tax advisor can help you determine if your improvement is "qualified."
Purchase real estate rather than leasing it. As the owner of the property, you get to deduct depreciation; as a lessee, you do not.
Increase the percentage of financing on your property. The more money you borrow to finance your purchase, the larger your depreciation deduction will be.
Invest in a property that is likely to have a long life. The longer the life of the property, the more depreciation you can claim.
As a passive investor, there are many rules and regulations to consider not only during tax season but throughout the years of property ownership. If you’re trying to embrace the “passive” part of passive investing, hiring a professional organization to assist you through the process can be a beneficial choice.