top of page

How Depreciating Your Real Estate Assets Can Save You Money

On one of my recent calls, I had a client ask me how he could leverage tax season to save his business money. He was running multiple businesses and anticipated having to pay a very large amount in taxes. Thankfully, I was working with his accounting team to clean up their books and had an easy recommendation that fit his company and long-term goals. I told him, “you can use your cash to buy cash-flowing properties and then depreciate those assets over time to save on your tax bill. ”Buying assets that we can depreciate will allow you to build long term wealth, reduce your taxes, and stabilize your cash flow.


"depreciation" by mikecohen1872 is licensed under CC BY 2.0.


What is Depreciation?


In accounting, depreciation is the act of spreading the cost of a physical asset (like a rental property) over a period of time. There are many different types of depreciation depending on the asset but, for the purpose of this article, we will stick to real estate.


There are also a few rules when it comes to depreciating your rental property. For example:

  1. It has to be owned by you

  2. You must use the property for business purposes

  3. The property has a determinable life, meaning that it wears out over time (unlike land which isn’t depreciable)

  4. The property is expected to last as an asset for more than one year.

By spreading the cost of the asset over a period of time the IRS allows you to use this as an income tax deduction and offset income you earned in the current period.


Depreciation Examples


Let’s examine an example of how depreciation works in the real world and how you can use it on your rental property.


Let’s say you buy a townhome with the intention of renting it out. When you purchase the property, you start by determining your cost basis. Your cost basis is the value of the home minus the value of the land the home sits on plus any closing costs and some improvements. You can make improvements to the property (like adding a new roof) and depreciate those improvements as well with some exceptions.


Let’s attach some numbers to this scenario. Say you buy a house for $250,000, subtract the land value at 25,000, and add in closing costs that are subject to depreciation. From here, you determine that your cost basis is $225,000.


Using depreciation, you would divide the cost basis by 27.5 years: which means you save a little more than $8,000 a year every year for 27.5 years or until you sell the property. If you were to make $100,000 on that property over the next decade then you would only end up paying taxes on $20,000 worth of income because of the depreciation the IRS allows you to receive.


How to Couple Depreciation with 1031 Exchanges


There’s one more thing to note about depreciated assets. When you sell the asset, the depreciation expense that you’ve taken is “recaptured” by the IRS and taxed as regular income. While this is a slight roadblock, there are still ways to get around it. However, there are ways around even that. For example, if you use a 1031 exchange (which I will talk about in another article) you don’t have to pay capital gains tax on the sale of the property. That is a double win for expense reduction!


Final Comments


Because rental property tax is complicated and changes periodically, it’s always recommended that you work with an accountant who is knowledgeable on real estate taxes. If you are looking for a bookkeeper to help manage your business finances or a fractional CFO to help coordinate taxes and grow your business please feel free to reach out to us.

Comments


bottom of page