Before Miranda and I started investing in real estate, we were vaguely familiar with the word “depreciation” but had no idea how it affected our real estate investing gains. We had heard that depreciation is a great “tax write-off” but had never found a use for it in our W2-income-earning lives.
Once we started investing in multifamily apartments, we learned the basics of depreciation and now enjoy the benefits of real-estate tax savings! And whether you’re investing in multifamily apartments, single-family homes, warehouses, or other real estate assets, understanding the basics of depreciation helps ensure you don’t miss out on tax-savings opportunities!
In general, there are three ways that real estate investors can calculate their property’s depreciation tax credit: straight-line depreciation, accelerated depreciation, or through bonus depreciation. While straight-line depreciation is the simplest, it will yield the lowest tax benefit, so most savvy investors will use accelerated depreciation and bonus depreciation.
Straight-line depreciation is a common accounting method to calculate an asset’s depreciation over its useful life. The method assumes that the asset depreciates at a constant rate throughout its life, and the depreciation expense is the same for each year of the asset’s useful life. For commercial real estate (such as multifamily apartments), the useful life is considered 27.5 years.
To calculate straight-line depreciation, you need to know the cost of the asset, its estimated salvage value, and its useful life. The estimated salvage value is the expected amount that the asset will be worth at the end of its useful life, and the useful life is the estimated length of time that the asset will be useful to the business.
To determine the depreciation expense for each year, you subtract the estimated salvage value from the asset’s cost and divide the result by the useful life. The result is the annual depreciation expense, which is recorded as an expense on the income statement and reduces the asset’s value on the balance sheet.
For example, if we buy a $10,000,000 property and subtract out the land value ($1,000,000), the IRS allows us to depreciate $9,000,000. If we divide that over the useful life of the property (27.5 years), we get to depreciate $327,272 each year. If the property’s cash flow is $300,000, we would pay no tax on the cash flow and would end up with a $27,272 net loss to carry forward.
Accelerated depreciation is a method of calculating depreciation for multifamily apartments that allow for a faster write-off of the cost of the property. Businesses typically use this method to reduce their tax liability and improve cash flow.
Under accelerated depreciation, the cost of the property is depreciated over a shorter time than the standard useful life of the property. This is achieved using a depreciation schedule that assigns a higher percentage of the property’s value to the earlier years of its useful life. This results in a larger depreciation expense in the earlier years of ownership, reducing the owner’s taxable income.
One method of accelerating depreciation is using the method of cost segregation. The cost segregation process involves a detailed analysis of the property to identify components that can be depreciated over a shorter time (typically 5, 7, or 15 years) than the overall useful life of the building (27.5 years for multifamily). This can include carpets, appliances, and fixtures, which have a shorter useful life than the building itself. By separating these items from the overall cost of the building, owners can depreciate them over a shorter period, resulting in higher depreciation deductions and lower tax liability.
Cost segregation can be particularly beneficial for multifamily apartments, which often have a large number of components that can be depreciated over a shorter period of time. This can result in a significant reduction in taxes and improved cash flow, which can be used for repairs, renovations, or other investments.
If we use accelerated depreciation on the same property, we get to “accelerate” the 5 and 15-year items over the first five years of ownership. This results in approximately 2x as much depreciation in years 1-5. As such, we now have a $654,454 annual depreciation credit to apply to our cash flow and other gains.
Bonus depreciation is a tax incentive that allows businesses, including owners of multifamily apartments, to recover the cost of qualified property more quickly by allowing an additional first-year depreciation deduction. Essentially, it allows a portion of the 5, 7, and 15-year accelerated depreciation to be taken in year one of ownership. 100% bonus depreciation means that 100% of the “accelerated” portion can be taken in year one.
Under current tax law, bonus depreciation allowed businesses to deduct 100% of the cost of qualified property acquired and placed in service between September 27, 2017, and before January 1, 2023. This meant that owners of multifamily apartments who purchased qualified property during this time frame could deduct the full cost of that property in the first year of ownership.
It’s important to note that 100% bonus depreciation was a temporary tax incentive and expired in 2022. The percentage of the allowable deductions will now gradually decrease each year. It will be 80% for the 2023 tax year, 60% for the 2024 tax year, 40% for the 2025 tax year, and 20% for the 2026 tax year, assuming that Congress makes no changes before then.
In addition to reducing tax liability and improving cash flow, bonus depreciation can positively impact the overall financial performance of multifamily apartments. By accelerating depreciation and taking it all in the first year of ownership, owners can free up funds that can be used for additional investments or improvements to the property. This can result in increased tenant satisfaction, higher occupancy rates, and increased rental income.
Overall, bonus depreciation is a valuable tax incentive for owners of multifamily apartments to consider when making improvements or purchasing new assets for their properties. By working with a qualified tax professional and taking advantage of this incentive while it is available, owners can improve their financial position and position their properties for long-term success.
When investing in a syndication apartment deal, the total bonus depreciation for the deal is typically allocated to the investors commensurate with their percentage of ownership. This amount shows up on your K1 and offsets the tax liability on your annual cash flow and/or gains.
If we use bonus depreciation, we get to bring a portion of the accelerated depreciation (80% in 2023) into year one of ownership. Although it varies by property, this usually means that approximately 30-35% of the property’s value can be accelerated into year one. For our $9,000,000 property value, that would mean $3,150,000 of depreciation at 100% (2017-2022) and approximately $2,520,000 at 80% (2023).
Depreciation is essential for multifamily property owners and investors to maximize tax benefits, increase cash flow, and build long-term equity growth. It’s important to note that the method of depreciation chosen will depend on various factors, including the type of property, its useful life, and tax laws. As general partners in multifamily deals, we always utilize an expert CPA firm and a cost-segregation professional to ensure we’ve followed the law and obtained the maximum tax benefit for all of us!