Investors rarely want to consider an asset declining in value, but the depreciation of real estate serves as a notable exception to that rule. Depreciation of multi-family properties actually provides a tax advantage to owners and is one of the greatest perks of investing in commercial real estate. Here’s what you need to know about depreciation and multi-family properties.
Life Bridge Capital is a leading real estate syndication company. We offer our investment partners the opportunity to leverage shares of multifamily rental properties into a passive monthly income. Learn More
What Is Property Depreciation?
Depreciation encompasses the concept that all property, except land itself, has a limited useful life. Just as the quality of a desk or sofa diminishes over time due to wear and tear, so do buildings, fixtures, and other improvements like sidewalks and parking areas. Some buildings and fixtures eventually become unusable as new technology or customs replace old ways of life as well.
The IRS permits the owners of income-producing properties to deduct the property’s purchase price and the value of its improvements from taxable income over the course of the property’s useful life. This effectively assigns a monetary value to that wear, tear, and obsolescence, allowing property owners to categorize it as a business expense and thereby reduce taxable income.
Rather than receiving a one-time deduction for the building’s purchase price and improvements, the owner can spread that tax deduction out over a number of years, usually 27.5.
How To Calculate Real Estate Depreciation
The Internal Revenue Service details the rules regarding deducting depreciation in Publication 527. Before claiming depreciation as a business expense, be sure to read and understand the publication and consult a tax professional, if needed. Several factors comprise the final depreciation calculation:
The Property Must Be Eligible for Service
Depreciation can be deducted from taxable income from the time property becomes available to rent—aka “going into service”—until it is retired from service. Temporarily removing it from service for repairs or renovation does not make the property ineligible.
Determine the Property’s Cost Basis
First, identify the amount to be depreciated over time. This is known as the cost basis. This is the amount paid for the property, minus the value of the land. On top of that, add the cost of any improvements paid for by the current owner.
Depreciation Occurs Over Many Years
Real property is depreciated over the course of 27.5 years or 30 years, depending on which depreciation method is used. Most owners calculate depreciation over 27.5 years under the General Depreciation System (GDS).
The Alternative Depreciation System (ADS) of 30 years is only used for properties that are used for business less than 51 percent of the time, are tax exempt, used primarily for farming, or financed by tax-exempt bonds. Owners must use GDS unless the IRS requires ADS or the owner meets the requirements and elects to use ADS.
Depreciation Terms of Other Property Types
Not everything in and on a multi-family property must be depreciated over 27.5 or 30 years. IRS Publication 527 breaks down several property classes, each of which has its own useful life ranging from 5 to 20 years. Table 2-1 in that publication details the recovery period for many items commonly found in multi-family properties.
For example, shrubbery and fences may be depreciated over 15 years. Carpet, furniture, and appliances have a recovery period of 5 years.
Properly categorizing and determining the depreciation period for the many asset types in a multi-family property is a big task, made even greater by the bonus depreciation options described below. Many owners engage the services of a professional to perform a cost segregation study. Those recommendations help property owners take maximum advantage of the depreciation deduction.
Tax Cuts and Jobs Act Bonus Depreciation Increase
Instead of following the IRS multi-year depreciation schedules described above, multi-family property owners can elect to expense items under bonus depreciation. Bonus depreciation refers to the large, one-time depreciation expense deduction that owners can take for many of the necessities that make multi-family buildings functional, like software and tangible property with a useful life of less than 20 years.
Common personal property for which owners take advantage of the bonus depreciation include fixtures, appliances, furniture, and software. Bonus depreciation also applies to exterior items like landscaping.
The 2017 Tax Cuts and Jobs Act (TCJA) increased the bonus depreciation amount from 50% to 100%. This means that the entire amount of these purchases can be expensed the same year they are purchased. Beginning in 2023, the bonus depreciation rate declines from 100% until it is completely phased out January 1, 2027.
Depreciation’s Impact on Taxable Income and Taxes Owed
Unfortunately, depreciation is unlikely to eliminate all tax liability, because it is a deduction rather than a credit—and because the percent taken each year is rather small. When a 27.5-year recovery period is used, the depreciation expense percentage for each year is just 3.636% of the property’s cost basis.
For example, a $500,000 property with a 27.5-year recovery period results in a $18,180 depreciation expense in a full calendar year ($500,000 x .03636 = $18,180). For properties not in service the full year, owners must proportionally reduce the amount of depreciation claimed.
Final Thoughts
The ability to reduce taxable business income by deducting depreciation expenses is just one of the many characteristics of real estate to consider when investing. Property owners can make the most of the depreciation deduction by consulting with a tax professional who can strategize the optimum time and pace to take the deductions to minimize taxes paid.
Life Bridge Capital is a leading real estate syndication company. We offer our investment partners the opportunity to leverage shares of multifamily rental properties into a passive monthly income. Learn More
