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"Rental Property Depreciation: the Gift that Keeps on Giving"
Rental property depreciation is one of the many tax deductions you can take advantage of while owning multifamily properties. The beauty of investment property depreciation is that you deduct it even though you do not actually "pay" for it with your own money! The only caveat is that when you sell you will have to pay taxes on all the depreciation you claimed under your ownership. But you'll still come out way ahead because it will be taxed at a lower rate (long term capital gains tax vs. ordinary tax).
WHAT IS DEPRECIATION?
Depreciation is an accounting (i.e., "paper") deduction that the IRS allows you to take for the overall wear and tear on your building. You can depreciate each of your multifamily properties over 27.5 years. The idea is that your property will deteriorate and will therefore need upgrading, rebuilding, etc., over time. Of course, this is ironic because we all know that real estate appreciates over time and not the other way around. But hey, who are we to argue with Uncle Sam? Note that rental property depreciation applies only to the structure and not the land on which it sits. The rationale is that land does not wear out, become obsolete, or get depleted and therefore cannot depreciate.
HOW DO I CALCULATE DEPRECIATION?
Obviously your accountant will do this for you, but I think it's still helpful for you to understand the methodology behind your investment property depreciation calculations. Let's say you buy a triplex for $200K. The land is estimated to account for 20% of the total value, or $40K, so the structure is valued at $160K. Simply divide $160K by 27.5 years to calculate your annual depreciation deduction. In this case, you can write off about $5,818 each year. One thing to keep in mind is that the calculation of depreciation can only begin when the property is ready for tenants. So if you buy a currently occupied investment property, depreciation begins immediately. If on the other hand you buy an unoccupied fixer upper, it'll only begin when the place is fixed up and ready to be rented.
CAN I CHOOSE NOT TO DEDUCT DEPRECIATION?
No, you have no choice! It's critical to deduct your rental property depreciation each and every year, because the government automatically assumes that you do. Whether you take it or not, when you sell, you will have to reduce your basis by the full amount of the depreciation you could have deducted. This is called "depreciation recapture." The effect of reducing your basis is that your gain will look larger, which will increase your capital gains tax liability. Let's go back to the previous example. Let's say you own that triplex for 10 years and you're now ready to sell. You've correctly deducted $5,818 in depreciation each year, for a total 10-year deduction of just over $58K. This will reduce the basis on which your taxable gain will be calculated to $142K ($200K-$58K). You then sell the property for $300K, so your taxable gain is $158K ($300K-$142K). The gain consists of 2 parts: $100K in asset appreciation and $58K in depreciation recapture. So again, when you sell, the IRS will assume that you previously deducted the $58K. Whether you did or not, it'll still be considered part of your taxable gain and you'll pay tax on it. The bottom line is that it would be foolish to not take advantage of your annual investment property depreciation deductions.
WHAT IF I FORGET TO DEDUCT DEPRECIATION?
Luckily, if you do make this mistake at least you'll have the ability to deduct past depreciation on your current tax return or amend your previous returns. The catch is that you can only go back 3 years. Another possibility is to have your accountant file IRS Form 3115 to change your accounting method to claim the correct amount of depreciation. In any case, you'll want to get the expert opinion of your accountant if you ever need to recover prior rental property depreciation.
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