Depreciation is an allowable annual tax deduction of the cost basis of certain assets held for rental or business-use. Depreciation is also referred to as “Cost Recovery”, “ACRS” or presently, “MACRS” (Modified Cost Recovery System). Depreciation is the nucleus of the real estate tax shelter. Here is why:
1. Depreciation is determined based on the entire cost of the property, regardless of how the property is financed. Thus, the amount of the depreciation is generally unaffected whether you paid all cash for the property or financed it 100%.
This is so even if the financing is non-recourse, where you are not personally liable. The combination of depreciation along with interest deductions can create high yields along with substantial tax losses.
2. You are not required to spend any funds for valuable depreciation deductions.
3. Yet, you pocket the tax savings, while the property is appreciating.
For example, a $10,000 depreciation deduction reduces your other income. In a rounded 30% bracket this will save you $3,000 in taxes. This is like free cash because you did not have to spend any additional money to get the deduction. Cash in, yet no cash out!
4. You get the deduction now and thus have sooner use of the tax savings, as an immediate source of down monies for other profitable real estate. For example, the tax savings of $3,000 from the previous example can be used as a down payment to acquire a bargain property. Again, this is like found money because you did not have to spend any additional cash to get the deduction.
5. Like cash in the bank, you can take the deduction and tax savings every year (over the recovery period of the property).
6. You can use the deduction to reduce ordinary income from rates as high as 40% down to ZERO.
7. Yet, when you sell, you do not have to pay any of these tax savings back. You can sell the property tax free via the powerful 1031 Tax-Free Exchange. You still continue to pocket the tax savings from depreciation! You get the best of all worlds!!
With creative planning, you can legally double and triple this already powerful deduction! Especially if you use or cost segregation template.
Any Drawbacks of Depreciation Can Be Reduced or Eliminated
Before proceeding any further, there are these potential drawbacks to depreciation deductions. Let’s briefly discuss them and then get them out of the way.
Passive loss limitations (PAL)
The PAL limitations attempt to put a limit on currently deducting rental losses against other types of income (such as business income, salaries, interest, dividends, etc.). Depreciation deductions are a big part of rental property losses.
In effect, PAL is a limitation on depreciation deductions. However, rental property deductions (including “paper” deductions) can still totally shelter current income from the property, allowing the property to generate tax-free cash flow. Also, unused PAL losses can be carried forward indefinitely to offset future passive income. More importantly, there are strategies to reduce or eliminate PAL limitations.
Reduces basis – increases gain
When property is disposed of, the entire amount of depreciation allowed or allowable must reduce the basis of the property, which in turn increases gain. However, don’t forget the sooner use of the tax savings from depreciation deductions.
You get the deduction now and thus have sooner use of the tax savings, as an immediate source of down monies for other profitable real estate. Moreover, there are numerous strategies that can defer, reduce or eliminate a taxable gain from the sale of real estate, including the depreciation portion of the gain.Ordinary income from “depreciation recapture”
Ordinary income from “depreciation recapture”
When a property is sold, depreciation recapture is the part of realized gain that is taxed as ordinary income because of certain “additional depreciation”.
Again, you have sooner use of the tax savings from depreciation deductions, plus there are numerous strategies that can defer, reduce or eliminate depreciation recapture.
Alternative minimum tax (AMT)
The purpose of AMT is to reduce the benefit of certain tax “loopholes”, known in AMT parlance as “preferences”. Certain depreciation deductions are “preferences” that may cause AMT. But they are generally not that significant of a preference item, plus there are AMT exemptions and planning strategies that can reduce or eliminate AMT.
The benefits of depreciation far exceed any drawbacks. Moreover, with planning, any such drawbacks can be reduced or eliminated. Unfortunately, many real estate investors and tax professionals do not take full advantage of depreciation.