Tax Advantages of Real Estate Investing: Understanding Depreciation
Depreciation is the IRS's method of acknowledging the decline in an asset’s value over time due to wear and tear. In real estate, investors can use depreciation as a tax-deductible expense to reduce taxable income. The IRS assigns a lifespan of 27.5 years for residential real estate and 39 years for commercial properties when calculating depreciation. While many assets qualify for depreciation, real estate investing offers particularly attractive benefits in this regard.
For example, let’s say you invest passively in a $20 million multifamily property, with $5 million raised from passive investors. Using a 39-year depreciation schedule, the annual depreciation for the entire property would be approximately $512,820 ($20 million ÷ 39 years). As a passive investor contributing $100,000, you’d receive 2% of this depreciation benefit (your share of the $5 million investment pool), amounting to $10,256 annually. Assuming a 20% tax rate, your potential tax savings could reach $2,051 per year.
If you qualify as a real estate professional—a designation requiring at least 750 hours of active involvement in real estate annually—you can use these passive depreciation losses immediately to offset other income. However, even if you don’t meet this criterion, the accumulated depreciation can still benefit you. When the property is sold, depreciation can offset profits from your share of the sale proceeds.
It’s important to note that when you exit a passive real estate investment, the IRS may require you to "recapture" the depreciation, taxing it at a rate of 25%. To avoid or delay this tax, many investors use a 1031 exchange, which allows you to reinvest your profits into another property, deferring taxes while continuing to grow your investment.
What Is Cost Segregation?
Cost segregation is a strategy that allows investors to accelerate depreciation by breaking down a property into its individual components, each with its own depreciation schedule. For instance, carpeting may depreciate over five years, while appliances might take seven. To implement this strategy, a third-party specialist conducts a detailed cost segregation study, typically involving an engineering assessment of the property.
Leveraging Accelerated Depreciation
The Tax Cuts and Jobs Act of 2017 introduced a significant benefit for real estate investors: the ability to claim 100% bonus depreciation in the first year of ownership. Instead of spreading deductions over 5, 7, or 15 years, you can claim the entire amount upfront. This provision offers a tremendous advantage for passive investors, especially when participating in large syndication deals. Imagine the financial impact of accelerated depreciation on a $20 million commercial property—an enticing opportunity for syndication investors!
Capital Gains Taxes and Self-Directed IRAs
Long-term capital gains tax rates, as of 2022, range from 0% to 20%, depending on your income. These relatively low rates make real estate an excellent vehicle for building wealth, whether your goal is to generate passive income for living expenses or create a legacy for future generations.
Self-directed IRAs (SDIRAs) and 401(k) plans offer additional opportunities for tax-advantaged investing. Many people assume these accounts are limited to stocks, bonds, and mutual funds, but that’s not the case. By opening an SDIRA, you can passively invest in real estate while enjoying the tax benefits of these accounts. If you’re interested, we can connect you with reputable custodians specializing in SDIRAs.
The Bottom Line
The tax benefits of real estate investing are powerful, but they shouldn’t be your sole motivation. Factors like the sponsor’s track record, the property’s location, and the deal’s financial structure are crucial to your investment success. That said, when combined with a solid investment strategy, these tax advantages can significantly enhance your long-term financial outcomes.