Depreciation is the key to taxation for real estate investors. Its the deduction that is unlike any other in that you are allowed to take a paper loss on an expense that you haven’t actually written a check for.
In other words the perceived loss in value because of wear and tear on the property is a deduction afforded to you by the government.To depreciate a rental property, you must first do what is called a cost segregation analysis to allocate the purchase price of the property to the three major groups.
More information on this can be found on the IRS Publication 527. The three general groups in which the property is divided into :
• Mortgage Interest
• Property Taxes
• Repairs and Maintenance
• Home Improvements
Not considered to be depreciable, land is very straightforward. It’s the piece of earth that your property sits on. The government thinks that land won’t go down in value and doesn’t need to be depreciated..
Considered to have a life of 27.5 years for residential (longer for commercial investments). Building is the structure itself, the home in this case. It is generally considered “immovable property”.
Considered to have a useful life of 5 yearsPersonal Property is considered “movable property”, i.e. appliances, light fixtures, furniture.
COST SEGREGATION ANALYSIS
When you buy a house for an investment you are tasked with assigning a value to each of these three groups.
As a raw example, if you buy the house for $200,000 you will assign values to each of the three categories.
Land – $32,500Building – $137,500
Personal Property – $30,000Total – $200,000
In the example above the land portion, which is not depreciable, will not gain you any depreciation deduction.
The building, which is depreciable over 27.5 years, will gain you a deduction of $137,500 / 27.5 = $5000 for 27.5 years.
The personal property which is depreciable over 5 years, will gain you a deduction of $30,000 / 5 = $6,000 a year for five years.
Based on this example your property would give a depreciation deduction in years 1-5 of $11,000.From years 6 – 27.5 your deduction would be just $5,000.
THE CATCH ?
You may be asking yourself why would the government give you such a fantastic phantom deduction ? You would be wise to have considered this too good to be true without some sort of take back.
The way that the government recaptures this otherwise lost revenue is through what is called depreciation recapture tax. It is important to note that if you are considering not taking the depreciation deduction to not complicate your tax matters or to avoid this recapture tax, that you would be hurting yourself.
The IRS can tax you on the depreciation recapture based on the allowable amount, whether or not you actually took the deduction.