Hi, my name is Brandon Hall and I'm a real estate CPA and the CEO of Hall CPA. Today I'm going to talk to you about the basics of depreciation.
First, let's talk about the purpose of depreciation. Depreciation is meant to track the deterioration of your asset over time. So, while it's true that real estate appreciates in market value, it's also true that your roof can literally fall apart. Your windows literally fall apart, your carpet gets torn up and literally falls apart.
Depreciation is a deduction granted to landlords. It's meant to track that deterioration over time and it's something that you're able to claim on your taxes every single year to shelter your net operating income (NOI) from taxes.
To show you the power of depreciation, let's use a high level example:
Let's assume that you purchase a rental property that generates $10,000 of net operating income and let's also assume that that $10,000 is your cash flow - so $10,000 actually hits my pocket. Let's also assume that you have depreciation of $11,000. When we report this rental on your taxes, we're going to see that net operating income of $10,000, but then we're going to decrease that net operating income by $11,000. So we're going to end up with a $1,000 tax loss and that $1,000 tax loss is reported to the IRS. And what this means for you is that you earn $10,000 of cash but you're telling the IRS that you actually lost $1,000, so you're not going to pay tax today.
On the $10,000 of cash flow that you received, the IRS thinks that you lost $1,000. Now whether or not you can claim that $1,000 tax loss largely depends on the passive activity loss rules and whether or not you have any other passive income from other passive activities.
But, if you do have significant passive income from other passive activities, or if your rental property is considered non-passive because you qualify for one of the exceptions to the passive activity loss rules, then what you can do is run a cost segregation study on your property and accelerate the depreciation claim.
So in the exact same example $10,000 net operating income, maybe instead of $11,000 of depreciation, I might have $30,000, $40,000, or $50,000 of depreciation in the year of acquisition, and that's going to create a large tax loss that I might be able to use to offset my other income.
Now, let's talk about how you actually calculate your annual depreciation allowance.
When you purchase a rental property, you have to make a determination as to what the building is valued at and what the land is valued at. You cannot depreciate the entire purchase price because the land does have value, and land cannot be depreciated because land does not deteriorate over time.
So if you purchase a property now, let's talk about how to calculate the annual depreciation allowance that you're going to claim on your tax returns.
When you purchase a rental property, you have to make an allocation between the building value and the land value. The entire purchase price cannot be depreciated because land has value and land does not deteriorate with time, so it cannot be depreciated.
Once we have a determination as to what that building value is worth, we're going to divide that amount by 27.5 years for residential rental properties and 39 years for non residential rental properties, and whatever that number gives you is your annual depreciation allowance that you're going to claim every single year on your tax returns.
So, every single year you're getting this tax benefit because depreciation is lowering your net taxable income from your rental property, and it's all thanks to you being a landlord.
Depreciation is reported on Schedule E for those of you that are reporting on your 1040, and on form 8825 for those of you that are reporting through an entity like a partnership or an S-corp.
Now, let's run through a few quick practical examples. Smaller cost purchases do not need to be depreciated as long as they are less than $2,500 thanks to something called the De Minimis Safe Harbor. But if you were to replace your roof, that is something that would be depreciated over 27.5 years (or 39 years for non-residential property).
If you were to replace your windows or your flooring and your property, all of that will be depreciated over 27 and a half or 39 years for non residential property, but making small repairs or replacing fixtures that are worth less than $2,500 will not require you to depreciate the cost of the replacement.
Brandon Hall is a real estate-focused CPA and the CEO of Hall CPA. Learn more about Brandon and his team over at https://www.therealestatecpa.com/