Maximizing Tax Benefits: Accelerated Depreciation in Real Estate

When you invest in real estate, you’ll benefit from equity appreciation, recurring income, and ample tax advantages. Along with write-offs, pass-through deductions, and deferrals, you can also take advantage of accelerated depreciation when filing your annual return. Depreciation involves the allowable deductions that owners can claim each year for the slight decrease in property value due to aging, obsolescence, and general wear and tear.

The accelerated depreciation technique allows you to use these deductions faster for your California home. The typical depreciation rate is 27.5 years, which means you could deduct a portion of your property value every year on your subsequent 28 returns.

In comparison, accelerated depreciation allows you to claim these deductions in five to seven years, offering many short-term advantages. This guide provides an in-depth look at accelerated real estate depreciation and how it can help you reduce the taxes you owe.

Understanding Accelerated Depreciation

Accelerated depreciation is an effective and proven strategy that allows investors to obtain a higher depreciation value soon after purchasing a property. In real estate, you’ll be able to depreciate your property’s moveable assets and fixtures faster than the 27.5 years of useful life the home has. You’ll be effectively front-loading depreciation expenses.

With this technique, you can deduct more of the depreciation in the initial five to seven years after you buy the property. The IRS also allows real estate to be depreciated over 15 years with the accelerated method. Remember that there are several options for accelerated depreciation, the primary of which is a double-declining balance. If you use this method, the depreciation expenses will be higher during the initial years and lower as the asset ages.

The traditional strategy is known as straight-line depreciation. This method allows real estate owners to depreciate their properties evenly over 27.5 years. For example, let’s say you buy a property valued at $750,000. You can divide the cost by 27.5 to determine how much the property depreciates yearly. The straight-line method allows you to claim $27,273 in depreciation per year.

Reasons for Accelerating Depreciation

There are many reasons why property owners may choose to accelerate depreciation. If you can claim higher depreciation to reduce your taxes, you’ll benefit from better cash flow during the initial years of owning the property. The IRS prefers that property owners claim the same amount of depreciation every year. However, they still allow accelerated depreciation. With this strategy, you can pull forward nearly 80% of the total depreciation.

If you owe capital gains taxes from selling existing assets, you can offset these costs by taking advantage of accelerated depreciation. Remember that a higher cash flow can also be helpful when adding other properties to your investment portfolio or repositioning existing assets through renovations or remodels.

Risks Associated with Accelerated Depreciation

While accelerated depreciation can be effective at helping you obtain more cash flow early on in an investment, there are some risks associated with this strategy. For example, you’ll reduce your long-term cash flow by compressing the depreciation schedule. Accelerated depreciation is designed to compress the standard 27.5-year period into a smaller number of deductions. Even though you’ll benefit early on, you won’t have access to steady depreciation after owning the property for five to seven years.

This strategy also leads to recapture taxation. You sell the property for a sizable profit within the 27.5-year timeline. Since you didn’t depreciate the value over the entire 27.5 years, the IRS will view your profit as recaptured depreciation, meaning it will be taxed as income. The IRS will also claim some of the deducted depreciation. You should expect taxes for recaptured depreciation to be as high as 25%. Your capital gains may also be taxed by up to 20%.

Several financial considerations should be considered before using this strategy. For example, you must obtain a cost segregation study if you intend to accelerate depreciation. Some appliances and systems in your home can depreciate quicker than others. Cost segregation studies help you determine how much of your depreciation can be deducted at a faster rate. However, these studies can cost anywhere from $10,000 to $25,000.

Impact on Tax Liability

Accelerated depreciation is a favorite among investors because it effectively reduces tax liability. When you perform this strategy, you’re effectively requesting an advance on the property’s total depreciation. The standard depreciation amount can help you reduce the amount of taxes you owe. However, the accelerated amount is superior in this regard.

Suppose you buy a $1 million property that depreciates by $36,364 annually for 27.5 years. If your take-home pay is $400,000 annually, you could reduce your taxable income to around $364,000. With accelerated depreciation, you can claim 80% of depreciation on your first five to seven returns. If you depreciate $800,000 over five years, you can reduce your taxable income by $160,000 annually. In this scenario, your taxable income would be just $240,000.

Choosing the Best Depreciation Method

It’s impossible to say which depreciation method is the best. It’s a subjective decision based on the one that’s right for you and your financial situation. It would be best to consider several factors when deciding which method to choose, including eligibility criteria and business goals. The requirements for claiming accelerated depreciation involve:

• You must own the home
• The property needs to be used to generate income, which you can do by renting it out

The two most common depreciation methods are accelerated and straight-line. If you choose the straight-line method, you can deduct the same amount annually for 27.5 years. The accelerated method lets you bring most of the property’s depreciation forward. The best method is the one that aligns with your goals.

Depreciation Recapture

You must pay taxes on depreciation and capital gains if you sell a depreciated asset and generate a profit. For 2023, capital gains taxes are capped at 20%, and depreciation recapture taxes are capped at 25%. These taxes also apply to different aspects of your profits. The portion that relates to depreciation will be taxed at a higher rate, while all non-depreciation gains will be taxed at the lower capital gains rate.

For example, let’s say you sell a rental property for a profit of $200,000. If you’ve already claimed $120,000 of depreciation while owning the home, this amount will be taxed at a higher rate. The $40,000 that remains will be taxed at 20%. If you sell your property at a loss, there won’t be any capital gains taxes.

Remember that a like-kind exchange can defer recapture taxation and capital gains taxes. However, you’ll still pay them eventually. Because of the significant tax implications associated with accelerated depreciation, it’s highly recommended that you calculate your taxes before implementing this strategy.

Advice for Implementing Accelerated Depreciation

Real estate investments are often meant to be held on a long-term basis. Before using this strategy, consider the future of your investment portfolio and the long-term plan for your property. Working with a reputable real estate CPA and a cost segregation professional is a good idea. While this technique can significantly reduce your taxable income, there are some risks you must deal with.

While accelerated depreciation is often best for investors who expect to hold their properties for 27.5 years, it’s possible to benefit from this strategy even with a short-term or mid-term hold. However, it can make things more complicated. The IRS will tax your sale proceeds at a higher rate if you opt for accelerated depreciation. An experienced CPA can help determine if this strategy is viable for you and your portfolio.

Conclusion

Like most real estate investment strategies, accelerated depreciation has its share of benefits and risks. If you use this technique, you can significantly reduce your taxable income for the first five to seven years of ownership. However, you may be tasked with paying higher taxes if you sell your property within the 27.5-year depreciation period.

If you believe that accelerated depreciation can improve your portfolio, do your research before using it as a tax strategy. It’s highly recommended that you seek expert guidance to help you navigate these complex tax matters in real estate investing.