The IRS realizes that an investment property will not last forever so the government allows investors to deduct an amount as depreciation to allow them to recoup their investment. Depreciation is the loss in value of an investment property over time due to wear and tear, physical deterioration and age. Real estate investors can depreciate their rental property and enjoy the positive cash flow resulting from the write-off of tax depreciation.
Only the cost of the building and improvements can be depreciated. Land cannot be depreciated. The IRS publishes tables that classify different assets into classes which determine the depreciation recovery period. Most accountants who are not aware of tax laws impacting real estate investors will generally attempt to allocate 80% of the cost basis of a property to the building and the remaining 20% to the land. The accountant would depreciate the building over 27 ½ years which is the recover period of the class that includes residential investment property.
It is possible to greatly increase your depreciation deduction by classifying components of your building into different classes that have a shorter recovery period. The most common classes used are five year personal property, 15 year land improvements, building and land. This method will yield a much larger depreciation deduction.
The first step is to break out personal property which will be depreciated over five years. Personal property can include furniture, carpets, appliances, cabinets, shelves, and window treatments. Each item is assigned a value based on current prices at stores like Home Depot, Lowes or Sears.
The second step is to break out land improvements which will be depreciated over fifteen years. This class includes improvements directly to or added to land. This can include landscaping, shrubbery, sidewalks, roads, pavements, parking lots, curbs, sprinkler systems, drainage facilities, waterways, canals, non-municipal sewers, fences, docks, bridges, radio and TV transmittal towers.
The third step is to calculate the cost of the building. To set the value of the building, an investor can use a number of methods such as independent appraisal, tax assessor’s valuation, insurance replacement costs and income capitalization. You should use the method that gives you the highest building valuation and the lowest land value.
Here is a case study showing how component depreciation compares to the traditional 80/20 method.
On January 1st an investor purchases a rental property for $ 100,000. The value of the personal property is calculated to be $ 15,900. Land improvements are entered at $ 10,200. The building is valued at $ 70,000. This leaves a remaining value of $ 3,900 for the land.
With the traditional method $ 80,000 would be allocated to the building and this amount would be written-off over 27 ½ years. This would result in a tax-write of depreciation of $ 2,909.
Using the component method the depreciation on these components is computed as follows:
Component Allocated Amount Depreciation
1. Personal Property $ 15,900 $ 3,180 (20% x 15,900)
2. Land Improvements $ 10,200 510 (5% x 10,200)
3. Building $ 70,000 2,440 (3.485% x 70,000)
4. Land $ 3,900 none
TOTAL $ 100,000 cost basis $ 6,130
The first year depreciation deduction is more than double the deduction using the traditional 80/20 method!
The component method can double or triple your depreciation deduction. If you owned enough real estate that had substantial depreciation losses each year, you could write off almost all of your salary income and end up paying no income taxes at all!
There are many ways to make a fortune investing in real estate. For more information about real estate investing visit my website at InvestInRealEstate101.
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