When I speak with clients about their real estate investments, this topic is always on my list to discuss in depth with them. Depreciation and Bonus Depreciation are hands down one of the best tax advantages to owning real estate for investment. Typically, that conversation starts with the threshold question: “What is Depreciation?”
What is depreciation?
Depreciation is a process utilized by accountants, CPAs, and Tax Lawyers to determine how much of the costs for buying and improving the property can be deducted. 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.
Per the IRS, there are requirements to depreciate rental property. Those requirements are:
- You must own the property (this doesn’t mean you can not have mortgage or other financing arrangement- simply that the property is titled in your name or your entity’s name);
- That property is income producing or used in your business (hopefully that means you are in real estate investing);
- Your property has a useful life, i.e, it loses its value from natural causes; and
- This asset is expected to last for more than a year.
One exception to depreciation is land. Land does not get used up. It is part of your property but not the depreciable part. Keep that in mind as you depreciate your properties.
You can start depreciating your properties as soon as you place them into service or, in non-lawyer language, when they are ready to rent. At the end of the year, your accountant, CPA, or Tax Lawyer will take the following steps to evaluate the deduction for depreciation of your property:
- Determine the basis of the property: This is simplified by considering this number as the price you paid for the property;
- Separate the cost of the land and buildings: As stated above, land is not depreciable so each part of the real estate has to be valued and separated;
- Determine the basis in the house;
- Determine the adjusted basis, if: Sometimes increases and decreases in your basis are necessary. This happens when you improve the property and those improvements have a useful life of at least 1 year before the property was placed into service, you spent money to repair a damaged property, adding utilities, and certain legal fees will add to your basis. Things that detract from 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.
Once all these steps are taken, 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.
What is bonus depreciation?
Now, imagine taking Depreciation and putting it on steroids. That is exactly what Bonus Depreciation is and it is a game changer in every sense of the term.
But first, it needs to be understood that Bonus Depreciation is not for the Real Estate itself, the land and structure. Bonus Depreciation is for Capital Assets with a life of less than 20 years. What does this actually mean?
Glad you asked because I was going to tell you anyway. 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.
Bonus Depreciation allows you 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.
Talk with your CPA, Accountant or Tax Attorney about both of these. There is no better tax advantage than these two concepts. Good luck out there!
Bio: Brian is a licensed attorney in Tennessee who handles commercial, real estate, construction, and business issues for clients. He and his wife also invest in real estate. To learn more about Brian, visit www.boydlegal.co
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.