Most real estate investors understand the significance of depreciation. In fact, many investors understand the basics of how to calculate depreciation. However, when it comes to investing through a partnership or multi-member LLC, investors can get confused as to how depreciation expense is booked and how it passes through to investors. Let’s take a closer look.
Depreciation itself is a non-cash expense. It represents a allowable tax deduction that for the recovery of the cost (or basis) of certain property. It represents an annual allowance for the “theoretical” deterioration and wear and tear associated with the property. It covers most types of tangible property, such as buildings, machinery, vehicles, furniture, and equipment, but is not allowable on land.
Depreciation will begin when the taxpayer places the property in service (ie starts to use it) in a trade or business or if it is used for the production of income. The property ceases to be depreciable when the taxpayer has fully recovered the property’s cost or other basis or when the taxpayer retires it from service, whichever happens first. Real estate that is held for rental income as an income producing activity is depreciable.
Depreciation is an Investor’s Best Friend
But to understand how depreciation works in the real estate crowdfunding environment, we need to first understand the crowdfunding structure. Depreciation would be applicable in a real estate crowdfunding “equity” deal as opposed to a “debt” deal. In a typical equity structure, the investor would own units (often called shares) in a limited liability company (“LLC”) that would invest into another LLC that holds the actual title to real estate (commercial building, apartment building, etc). Typically, you would call the LLC that holds title to the property the “holding” company or entity.
Based on this structure, the investor holds essentially an indirect equitable interest in the real estate and participates in the economic upside (and even downside) of the property itself. As such, the investor is a partner in a partnership structure. So considering this equity structure, let’s take a look at how depreciation is calculated and recorded.
First of all, depreciation is calculated at the “holding” company level, not by the individual investor. The holding company will record depreciation using a straight-line basis over 27.5 years for residential rental property (single family homes, apartment buildings) and 39 years for commercial property (office buildings, etc). A shorter useful life is assigned to items such as appliances and other building assets. Thanks to tax reform, depreciation deductions have been accelerated.
Let’s Look at an Example
For example, assume that an apartment building is being purchased for $3,500,000. Let’s also assume that the land value is $750,000. We would deduct the land value from the overall purchase price, deriving a depreciable basis of $2,750,000. Since this is residential real property, we would assign a life of 27.5 years and thus calculate annual depreciation of $100,000 ($2,750,000 divided by 27.5 years). This expense is then recorded by the holding company LLC.
Since the depreciation is recorded at the holding company level, the real estate investor does not actually record the depreciation. As a result of depreciation expense, net income is lowered and the taxable income from the Form K1 will likely be lower than any distributive cash flow. This is a major benefit to real estate crowdfunding investors.
Depreciation can really be a real estate investor’s best friend. Fortunately, real estate crowdfunding investor’s don’t need to be concerned with any specific calculations. As with any investment, make sure to discuss the tax specifics with a qualified CPA or tax professional so that you understand the tax issues as they relate to your specific situation.