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, given the recurring revenue streams generated from multiple rental units within an apartment project. 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, how to use the depreciation expense to reduce taxable net income, and how to calculate tax savings due to depreciation in three easy steps.
What is Real Estate Depreciation?
The term “depreciation” is used to describe the decline of an asset’s value over time. For example, cars depreciate the minute you drive one off the lot, and manufacturing equipment and computers all eventually wear out or depreciate.
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. That is because tax laws in the U.S. allow real estate investors to take an annual deduction for depreciation that 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, reducing 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.
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.
Located on Jackson Square in the French Quarter, the property was built in 1850 and is often cited 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 that the value of the land the apartment building sits on is excluded because 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 but 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 investor $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
Real estate can only be depreciated if it meets all of the following four requirements:
- An investor 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, B could not claim a depreciation expense because he does not own the property. On the other hand, Investor A could depreciate the property because he owns it, even though he is renting the entire property to Investor B.
- Real estate must be used 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.
- The more than one year rule for depreciation is also the reason why fix-and-flip real estate investors generally cannot claim a depreciation expense because the property is held for less than one year.
- Another exception to the one-year rule is developers. Lots and the homes built on the lots are considered stock in trade by the IRS and cannot be depreciated by the developer, even if the subdivision takes more than one year to build and sell out.
- Property must have a determinable useful life. That is why repair and maintenance costs are expensed the same year they are incurred as immediately deductible expenses.
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 cannot be depreciated because the land is never used up and has a useful life that theoretically goes on forever.
Calculating Real Estate Depreciation in 3 Steps
Now let us take a more detailed look at how to calculate real estate depreciation using our multifamily property in Cleveland as an example. In this example, we are also going to adjust the property cost basis by including costs that must be depreciated over the useful life of the property.
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. To calculate the cost basis, subtract the land value from the total purchase price, then add the settlement fees that must be capitalized over the useful life of the property.
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.
The federal taxes saved from real estate depreciation are calculated by adding up each annual depreciation expense and multiplying 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 is usually the price paid for the property, less the cost of the land, plus other costs such as settlement fees, as shown in the above 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 – along with recurring cash flow and potential appreciation in property value over the long term – is one of the biggest benefits of investing in income-producing real estate. Depreciation is a non-cash expense used to reduce taxable net income from investment real estate. 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.
Suburban multifamily assets in the Midwest and Southeast are predicted to provide the best investment opportunities for reliable market performance and expected returns. Multifamily markets such as Columbus, Cleveland, and Cincinnati should continue to be among the best performing in the country.