Let’s talk about depreciation, including bonus depreciation.
If you’ve invested in apartments then you likely know just how tax advantaged real estate is. Depreciation is the cornerstone of those tax benefits. But depreciation isn’t always well understood. So let’s change that.
In accounting terms, depreciation is the reduction in value of an item over time. Take, for example, computers purchased for a business. Those computers will have their highest value on the day they’re first put into service. After that, they go down in value with the passing weeks, months, and years. In other words, they depreciate in value.
Different assets have variable life spans, so the IRS estimates the “useful life” of a whole host of assets. With respect to apartments, they historically chose 27.5 years as the useful life.Clearly, their estimate doesn’t comport with reality. If it did, then there wouldn’t be any apartments older than the 1990’s. And we all know that the U.S. is flush with 1980’s, 1970’s, 1960’s and older apartments.
The vast majority of these properties haven’t depreciated in value. In fact, most have seen significant appreciation through the decades. Nevertheless, the IRS has set the schedule at 27.5 years.
Straight-Line Depreciation Example
Having the ability to depreciate an appreciating asset is a real gift. It creates a phantom or paper loss that can be used to offset actual gains. So in the case of apartments, depreciation is a paper expense that lowers ones tax burden without impacting profits.
Let’s look at an example of how it works.In this example, let’s say that 50 investors each contributed equally to purchase a $34 million apartment building. For reporting purposes, that property has two components – the land and the “improvement.”
The improvement consists of all enhancements to the plot of land (structures, parking lot, sidewalks, etc.). It has to be divided this way since land can’t be depreciated. However, the improvements can.
Hypothetically speaking, our $34 million property has a land value is $6.5 million. Subtracting out the land value from the purchase price, yields an improvement value of $27.5 million.
$34 million (purchase price) – $6.5 million (land value) = $27.5 million
That $27.5 million improvement gets depreciated over a useful life estimate of 27.5 years. Utilizing straight-line depreciation, it yields $1 million in paper losses each and every year for the next 27.5 years.
$27.5 million (improvement value) / 27.5 years = $1 million (annual depreciation)
Equally dividing that depreciation benefit among those 50 investors yields $20,000 of paper loss for each to take against actual gains from profits.
Depreciation is a wonderful tax-deferral strategy. It allows the bulk of our investors to avoid paying current year taxes on quarterly distributions. And they’ve been legally doing it for years.
Accelerated Depreciation – How To Depreciate Faster
As nice as straight-line depreciation is, you should learn about accelerated depreciation. It allows you to frontload the depreciation benefit.
Accelerated depreciation requires a cost-segregation study. These studies identify all of the non-structural elements and land improvements and place a value on them.
Those items can then be depreciated over shorter time schedules. The non-structural elements get labeled as personal property and get depreciated over five or seven years. The land improvements utilize a 15-year schedule. Accelerated depreciation creates larger paper losses in the early years of ownership.
The paper losses from depreciation can offset current yield from the property for many years. And if there’s excess depreciation, it can be used to offset K-1 passive activity gains from other sources.
Any remaining, excess depreciation, after offsetting all of your passive activity gains, gets banked and carried forward until you can use it. So you don’t lose it if you can’t use it in that calendar year.
Looking at an example can make this concept clearer. Consider two investors each placing $50,000 into a property. Their annual yield is 6% or $3,000. Each receives $8,000 in depreciation annually. Investor one has no other sources of passive income, outside of this property. However, investor two has $4,000 of passive activity gains from another source.
$3K yield – $8K depreciation = $0 tax on yield in current year and -$5K of depreciation benefit banked for a future year.
$3K yield + $4K in other passive gains = $7K in total passive activity gains.
The $8K in offsetting depreciation = $0 tax on yield and $0 tax on the other passive activity gain in the current year. Plus the remaining $1K of depreciation gets banked for future use.
As you can see, tax deferred passive income is incredibly beneficial.
Bonus Depreciation – A Way To Offset Unrelated Passive Gains
Bonus depreciation is something new to our space. Historically, it’s been reserved for brand new properties or new construction.
Bonus depreciation is also called additional first year depreciation deduction. As the name implies, this benefit allows a large percentage of an asset to be depreciated and deducted in year one.
You still have to utilize a cost segregation study to identify and value “personal property” and land improvements. Personal property gets deducted over five or seven years. Land improvements receive a 15-year schedule. It used to be that bonus depreciation allowed owners of new properties to take 50% of those in year one.
However, the Tax Cuts and Jobs Act made two changes to bonus depreciation that are material. First, it got expanded beyond new properties. Used properties are now eligible for the same benefit. Second, the benefit increased from 50% to 100% through 2023.
So we can throw away the accelerated depreciation schedules for now and get all of that frontloaded depreciation benefit in year one. This is particularly helpful for those that have significant K-1 passive activity gains from other sources.
Several investors are opting to buy more apartments right now to take advantage of the powerful benefit of bonus depreciation.
For those with passive activity gains from other sources (as reported on a K-1), bonus depreciation provides excess depreciation to offset them as well.
There are many reasons to hold commercial multifamily real estate in your portfolio. The tax advantages are tremendous. And understanding depreciation is critical in deciding what level of investment into apartments is best for you.
For those with significant taxable gains from passive income, bonus depreciation could be a way out. Just be sure to consult with your trusted tax advisor first to make sure that it can work for you and your situation.
If you’d like to learn more about depreciation, accelerated depreciation, bonus depreciation and several other tax benefits associated with real estate, be sure to watch my free webinar:
The Tax Benefits of Apartment Investing
Also, I’d like to invite all accredited investors to join the conversation and become better investors by joining the Accredited Investor Network.