Depreciation for Dummies
If you rent out a home as part of your master plan to build wealth, you probably have some blind spots when it comes to depreciation. Those blind spots often result in a tip for the tax man. Let’s check six on depreciation of rental homes.
Depreciation 101
Depreciation is the concept that an item has a useful life and at the end of that useful life, generally isn’t worth much, if anything, economically. Residential rental property, somewhat arbitrarily has a tax law-defined useful life of 27.5 years. This doesn’t apply to your personal residence because depreciation is for business assets.
If you rent a home out, you must depreciate the home evenly over 27.5 years, then “recapture” the depreciation when you dispose of the home. More on this later…
Depreciation 201: Fair Market Value and Basis
Basis of a rental property that you bought for investment purposes is the purchase price plus certain acquisition costs plus capital improvements (not maintenance and upkeep). The basis of a home that you convert from your primary residence to a rental is more complicated and more frequently porked up.
The basis of a converted home is the lesser of the fair market value (FMV) on the date of conversion, or the adjusted basis at that time. Cue the confusion.
Let’s say you paid $275K for your home, paid no acquisition costs, made no improvements, and experienced no appreciation, then converted it to a rental. The FMV and basis are both $275K. You’ll depreciate the home over 27.5 years, taking $10K of depreciation per year. This results in $10K of “paper loss” on line 18 of Schedule E of your tax return. This is the primary source of “tax advantage” of owning rental real estate.
Same jet, new day… You paid $275K but the market skyrocketed and the FMV is $550K when you convert. Your basis is still $275K. You can’t take $20K per year of depreciation to juice your paper losses each year because the basis for depreciation is the lesser of FMV at conversion and the basis in the property.
It’s important to know your basis prior to placing the property into service. If you added to basis by installing a pool, driveway, or new roof, you’ll get a tax tailwind.
Depreciation 301: Tax Benefits
As mentioned above, depreciation shows up as an expense on your tax return. You add it to other costs like insurance, property taxes, management fees, repairs, etc. In the early years of a rental, it frequently generates a paper loss. You could receive $30K in rental revenue but have $35K of rental expenses. If $10K of those expenses came from depreciation, you still have $5K in your pocket to spend.
Logging depreciation each year is not optional, but many new landlords that self-prepare taxes goober it up. If you don’t claim depreciation on your tax return, you effectively report higher income and therefore pay higher taxes. You leave a tip for the tax man. What’s more, you can’t file an amendment for a refund more than 3 years back. If you started this cascade 10 years ago, you lost out of many years of beneficial depreciation deductions.
If you realize this has occurred, you can correct it by filing the proper forms, but it’s probably time to start using a solid tax professional to help with this going forward.
The IRS expects you to depreciate the property and they’re going to settle up with you when you dispose of the property.
Depreciation 401: Recapture
When you deduct depreciation over the period you rent out a home, you get a tax tailwind each year. However, there is no free lunch. When you sell the property, Aunt IRS wants you to pay back that tailwind in the form of “depreciation recapture.”
Let’s say you rented a property for 5 years, deducting $10K of depreciation each year for a total of $50K. When you sell, you must pay depreciation recapture tax on that $50K. The rate for this tax is a maximum of 25%, but is often less because it’s your ordinary rate which could be 22% or 24%, maybe less.
Depreciation recapture is unavoidable if you sell the property. Regardless of your ability to use the Section121 “2 of 5” of “2 of 15” rules for active military, the first dollars of gain will be taxed as depreciation recapture.
What’s more, the IRS taxes depreciation as “what you actually depreciated” or “what you should have depreciated.” If you depreciated your property correctly, these are the same number.
Unfortunately, some landlords fail to depreciate the property on their tax return and don’t get the annual tax tailwind, but then still have to pay depreciation recapture tax upon sale.
Depreciation X01: Advanced Ninja-Jedi-Patch Sorcery Level Stuff
If you’ve read this far, congratulations. Let’s get to some other nifty depreciation topics.
Swap ‘til you drop. The most common technique for kicking the can on depreciation recapture tax is to perform a 1031 exchange. This “swap” involves exchanging your current business real estate for other business real estate property(s). You can’t exchange into a boat or tractor, just real estate. But you can exchange into land, strip malls, or multi-family homes. 1031 exchanges are a book unto themselves but the major gotchas are:
- You must use a qualified intermediary to hold funds from the sale through the purchase of new property. You can’t take possession of the money at closing.
- Your new property(s) must be of greater value and with equal or greater debt.
- You must identify the new property(s) within 45 days of closing on your sale.
- You must close on the new property(s) within 180 days of closing on your sale.
Thus, you need to plan well in advance to execute a 1031 exchange. Too many families hear about this as they’re staring down a tax bill and fantasizing about tax relief.
A 1031 exchange defers taxation on depreciation recapture until sale of the newly acquired properties. The depreciation recapture tax bill keeps growing… except that basis on the properties is “stepped-up” to fair market value at death. If you hold on to property until you die, your heirs get it with a basis equal to its current value and the depreciation recapture tax bill goes poof.. under current tax law… which is written in pencil.
Before getting too excited about “swap ‘til you drop,” talk to your nearest living relative over 90 and ask a few questions like, “Do you still own rental property?” “Do you still manage it?” You may find that your decades-older self loses a bit of interest in owning commercial property over the years…
Accelerated Depreciation. If some depreciation is good, more must be better right? Twenty seven and half years is a long time to wait for all the benefits of depreciating your slum empire. But the subcomponents of your properties have different service lives such as 3, 5, 7, and 15 years. By performing a cost segregation study to break out and separately depreciate those items, some of which you may be able to take even more accelerated depreciation on, you can get a sugar high of depreciation in the early years of ownership. This can improve cashflow and profitability, but remember, this depreciation must be recaptured too. If you must sell rather than exchange the property, you could be facing a much higher tax bill than if you just depreciated the whole property over 27.5 years.
There are other options to avoid depreciation recapture tax, specifically Qualified Opportunity Zones and Delaware Statutory Trusts. I would be hard-pressed to recommend either to most folks so off to the googles with you for more information about these tools.
Cleared to Rejoin
Friends don’t let friends get whacked by depreciation. Like Backdoor Roth Club, you should probably talk about depreciation as soon as you start renting out a home. If you self-prepare taxes, strongly consider hiring a professional at least for the first year you own the home and certainly the year of sale. You can skip out on paying depreciation recapture tax, but it’s literally a lifetime commitment and subject to the whims of Congress. If you think you might have a depreciation problem lurking on your tax returns, now is a great time to reach out to a good tax professional to get back on course.
