Depreciation in Real Estate helps lower your tax liability and is recorded as a loss on paper. Commercial and residential buildings can be depreciated over 39 years while residential is 27.5 years.
Under some circumstances, you may be able to use what’s called Accelerated Depreciation.
Accelerated Depreciation involves shortening the depreciation timeline for an asset. In the first year of ownership, you might depreciate an asset for the equivalent of two or more years. This would then coincide more closely with the current value of the asset. While the remaining years are relatively the same if you’re using a straight line method.
Before you can accelerate the depreciation you’ll have to go through a Cost Segregation Study. A Cost Segregation Study will help break up the various assets of the property and determine what the current useful life may be for each item listed on the report.
For example, the useful life of a roof may be completely different from that of an appliance.
Types of Accelerated Depreciation
- The Double Declining Balance is exactly what it sounds like, you would double the rate of depreciation based on the asset’s remaining life.
- The Sum of the Years Digits involves using different rates for different years. For example, an asset with a five-year life would have a base of the sum-of-the-digits one through five, or 1 + 2 + 3 + 4 + 5 = 15.
The Disadvantages of Depreciation
Depreciation will lower your tax liability, but it will also be taxed when you sell the property at the ordinary tax rate while the remaining profits will be taxed as capital gains. One way to avoid paying taxes on the sale of a property is through a 1031 exchange.
What You Can’t Depreciation
You can’t depreciate land, so you’ll have to establish what the structure is worth versus what the land is worth and only depreciate the structure
You can’t depreciate a property you’ve fully depreciated, such as 27.5 years for residential.
You can however start depreciating property as soon as it’s ready to be rented.