Table of Contents
Real estate is a tangible, physical asset sought after by investors for the income it produces.
Many real estate investors view the income potential of multifamily property as the most stable of all commercial real estate asset classes. People often view it this way because an apartment project generates recurring revenue streams from multiple rental units. Multifamily investment demand remains strong and steady, with volume projected to rise to $148 billion in 2021.
However, commercial real estate also offers a unique benefit that other assets do not that can significantly increase an investor’s return: real estate depreciation.
In this article, we will discuss how depreciation in commercial real estate works. We demonstrate how to use depreciation expense to decrease taxable net income. Additionally, we explain how to calculate the tax savings from depreciation in three straightforward steps.
What is Real Estate Depreciation?
People use the term “depreciation” to describe how an asset’s value declines over time. For example, cars depreciate the minute you drive one off the lot. As for manufacturing equipment and computers all eventually wear out or depreciate.
Benefits of depreciation
Depreciation usually refers to a decrease in value. However, when it comes to real estate, depreciation is just as beneficial as passive income, if not more. That is because tax laws in the U.S. allow real estate investors to take an annual deduction for depreciation. This annual deduction then reduces the amount of taxes paid on the net income the property generates.
A real estate investment such as multifamily property appreciates over time, creating more value for the investor. As the property generates annual income, the building value also simultaneously depreciates. Overall dropping the taxes paid on a property that is appreciating in value.
Although depreciation normally describes a loss in value,
depreciation in real estate is actually
just as big a benefit as passive income, if not more so.
According to the IRS Publication 527, commercial real estate depreciates over a period of 39 years while residential property – including apartments and multifamily buildings – depreciate over 27.5 years. After that time, the property is completely worn out, at least for tax purposes.
Upper Pontalba Building
Of course, common sense says that real estate still has value even after the IRS says the property is fully depreciated. Take the Upper Pontalba apartment building in New Orleans, for example.
The property stands on Jackson Square in the French Quarter and dates back to 1850. Many people consider it as the oldest apartment building in the country. In keeping with IRS guidelines, the building would have fully depreciated well before 1900.
Yet, in 1935, the original 16 townhomes in the Upper Pontalba Building were converted to 50 apartment homes. In 1995 the historic building underwent a multi-million dollar renovation to upgrade the property’s mechanicals.
Today, apartments in Upper Pontalba rent for about double the market rate, and there’s a waiting list for available units.
Based on the most recent public market rent study for the Upper Pontalba Building (2015), the luxury residential units have an annual potential gross income of about $1.3 million. With luxury metro Class A multifamily property in New Orleans trading for a cap rate of 4.38%, the multifamily building has a value of at least $30 million, based on a rental income study from six years ago.
Not bad for a multifamily property that wore out over 130 years ago!
How to Use Real Estate Depreciation
Of course, most multifamily investors are not buying historic apartment buildings in Louisiana. According to CBRE’s Multifamily 2021 U.S. Real Estate Market Outlook, suburban multifamily assets in the Midwest and Southeast will provide the best opportunities for solid market performance, including Cleveland, Ohio.
But regardless of where you invest, real estate depreciation is used the same way. Here is a quick look at how multifamily investors use real estate depreciation to reduce taxable income.
In this example, we will follow the IRS guidelines for depreciating a multifamily building over 27.5 years, interior improvements such as built-in appliances over five years, and a landscaping fence built around the property over 15 years. Note, the value of the land the apartment building sits on is excluded. It is important to note that land does not wear out for depreciation purposes.
Assume the market value of a multifamily building in Cleveland is $5 million (excluding the land), and the investment generates a pre-tax net income of $300,000 each year. The combined value of the appliances in all of the units – items such as refrigerators, washers and dryers, and stoves and ovens – is $100,000, and the fence costs $50,000 to erect.
Using annual real estate depreciation to reduce taxable net income would look something like this:
- Building depreciation: $5 million / 27.5 years = $181,818 annual depreciation expense
- Appliance depreciation: $100,000 / 5 years = $20,000 annual depreciation expense
- Fence depreciation: $50,000 / 15 years = $3,333 annual depreciation expense
The total real estate depreciation reduces the taxable net income on the multifamily property in Cleveland by $205,151:
- Pre-tax net income = $300,000
- Building depreciation = – $181,818
- Appliance depreciation = – $20,000
- Fence depreciation = – $3,333
- Taxable net income after depreciation expense = $94,849
Benefits of Showing Investment Property Tax Depreciation
In the above example, the investor still has $300,000 of net cash income. However, is only paying taxes on $94,849 thanks to benefits of depreciation. The tax savings generated by investment property depreciation can quickly add up.
There are seven federal income tax brackets for 2021, with rates ranging from 10% to 37%. Assuming an investor’s income for the year is $550,000, the tax rate is 35% for married individuals filing a joint return.
The $205,151 depreciation expense on the multifamily property saves the individual $71,803 in federal income taxes.
Instead of paying a tax of $105,000 on the property’s net income of $300,000. The investor pays a reduced tax of $33,197 on the $94,849 of taxable income after depreciation expense.
Related: Real Estate Funds vs. REITs
Investment Properties Depreciation Requirements for Tax Deduction
To depreciate real estate, it must meet all of the following four requirements:
- An individual must own the property, even if there is a mortgage on the property. For example, if Investor B sublets the entire property from Investor A. This means that B could not claim a depreciation expense because he does not own the property. On the other hand, Investor A could in fact depreciate the property because he owns it, even though he is renting the entire property to Investor B.
- To qualify for depreciation, real estate must serve for a business or income producing activity, such as rental property. That is another reason why Investor A can take the depreciation expense and Investor B can not.
- Property is expected to last more than one year. The building itself, along with capital improvements such as appliances, a fence, or a new roof, is expected to last much longer than one year and is depreciated accordingly.
- Real estate investors who “fix-and-flip” a property often times cannot claim a depreciation expense. Frequently, the property is held for less than one year, which fails to meet the “more than one year” guideline.
- Another exception to the one-year rule is developers. They often consider both lots and the homes built on them as stock in trade. Even if the subdivision takes more than one year to build and sell out, the developer cannot depreciate it.
- Property must have a determinable useful life. Expense for repair and maintenance can be deducted immediately, implying they can be expensed in the same year they are incurred.
Useful Life Criteria
Residential real estate, such as a multifamily property, has a useful life determined by the IRS of 27.5 years. This is also why land does not meet the depreciation criteria because it has an indefinite useful life and never depletes.
Calculating Real Estate Depreciation in 3 Steps
Now let us take a more detailed look at how to calculate real estate depreciation. We will use our multifamily property in Cleveland as an example. In this example, we will adjust the property cost basis by incorporating expenses that should be depreciated over the property’s useful life.
We will assume the following:
- Purchase price = $5.5 million including land value of $500,000
- Settlement fees = $25,000 including utility installation, legal and recording fees, surveys, and title insurance
- Improvements made after closing = $100,000 for appliances and $50,000 for a new fence
Step 1: Calculate the cost basis
Determine the property basis for depreciation purposes. Calculating the cost basis involves subtracting the land value from the purchase price. Then adding capitalized settlement fees over the property’s useful life.
For this example, the basis used for depreciation is $5,025,000 : $5.5 million purchase price. $500,000 land value = $5 million + $25,000 settlement fees.
Step 2: Calculate the real estate depreciation
We have three depreciation schedules: 27.5 years for the building basis, 15 years for building a certain improvements, and 5 years for the appliances.
The next step is to calculate the real estate depreciation. In this example, we have three depreciation schedules: 27.5 years for the building basis, 15 years for building a new fence, and five years for the appliances.
- The building has an annual depreciation expense of $182,727: $5,025,000 building cost basis / 27.5 years
- Annual depreciation expense for the new fence is $3,333: $50,000 fence cost / 15 years
- Depreciation expense for the appliances is $20,000: $100,000 total cost of appliances / 5 years
Step 3: Calculate the tax savings
Calculate the tax savings created by the total depreciation expense. If the investor is in the 35% federal tax bracket for 2021 (earning between $418,851 to $628,300 and married filing a joint return), the taxes saved due to depreciation are $72,121.
To calculate the federal taxes saved through real estate depreciation, add up the annual depreciation expense and multiply it by 35%:
- Building depreciation = $182,727 x 35% = $63,954
- Fence depreciation = $3,333 x 35% = $1,166
- Appliance depreciation = $20,000 x 35% = $7,000
- Total federal tax saving due to depreciation = $72,121
Total tax savings may be even more, depending on the state and city the investor lives in. For example, residents of high-tax states such as New York, Oregon, Maryland, and California could save an additional 3.78% to 4.96% in taxes when using a depreciation deduction to reduce taxable income.
A Closer Look at Basis of Depreciable Property
The cost basis of rental real estate usually includes the property’s purchase price minus the land cost. Additionally, other expenses such as settlement fees can be included, as shown in the example. The basis is also adjusted for depreciation purposes and can be increased or decreased:
Increases to property basis
Property basis may increase during the holding period of the property. Items that add value to the property and increase the basis include:
- Additions or improvements that have a useful life of more than one year.
- Assessments for local improvements that increase the property value, such as streets or sidewalks.
- Cost of extending utility service lines to the property.
- Legal fees such as perfecting title or settling zoning issues.
Decreases to property basis
Items that represent a return of the cost of the property decrease the basis, including:
- Money received for granting an easement.
- Insurance payment received as the result of a casualty or theft loss.
- Casualty loss not covered by insurance for which a deduction was taken.
- Exclusion from income of subsidies for energy conservation measures.
Depreciation in real estate is one of the biggest benefits of investing in income-producing real estate. Investment real estate uses depreciation as a non-cash expense to decrease taxable net income. Thanks to depreciation, investors pay less in taxes while keeping more cash as profit to reinvest.
“Depreciation is a non-cash expense used to
reduce taxable net income from investment real estate.”
Depending on the pre-tax net income generated by a real estate investment and an investor’s tax bracket. Tax savings from depreciation could be tens of thousands of dollars each year.
While other commercial real estate asset classes have struggled over the last couple of years. Multifamily rental property has consistently outperformed.
Investment opportunities with expected stability and returns are likely to come from suburban multifamily assets in the Midwest and Southeast. Multifamily markets such as Columbus, Cleveland, and Cincinnati should continue to be among the best performing in the country.