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  • Depreciate or not

    I have a hard time understanding depreciation. Let's say I bought a property for 100 K ( the building itself) and depreciate it for 27 and half year. It's worth is 300 K now. I am in a %30 bracket. So, If I had not depreciate it, then I would pay %40 on 200K capital gain, but since i depreciate it, I will end of paying %40 on 300K. Is this correct? How much really is the tax advantage for a high bracket earner? Could you show the math please. Thank you.

  • #2
    You are not correct. Here is my best stab. I am not a real estate CPA, and you really REALLY need to talk to one of them. I only write this to illustrate that depreciation is, indeed, great for a high tax bracket earner and all real estate investors.

    Depreciation recapture is 25%. Your tax rate is above 25%. That's why you win, in simple terms. Long term Capital gains (what you would pay on this investment) is currently 20%, and only applies to the profit over the initial purchase price.

    For example:
    You buy a property for $100k. Depreciate that at 3.6% per year, or so, for 10 years. Each year you get to write off $3600 in income to depreciation, so you save 30% on $3600/year, or about $1000 (rounded for easy numbers). After 10 years, you decide to sell the building, now worth $300k. You've written off $36,000 in depreciation, so your basis in the building is now $62000 instead of $100000. You will pay 'depreciation recapture' tax (25%) on the $36k you depreciated, and then long-term capital gains (20%) on the $200000 in gain.
    Focusing on the depreciation piece, you will pay $9000 in depreciation recapture at the end, but you saved a bit more than 10000 through depreciating (if your tax rate was 30%). So you end up $1000 ahead, but also the $9000 in year ten is worth less than the $10000 over time due to inflation. So you really do come out ahead.

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    • #3
      +1 JacobC -- to add-- there's no choosing to depreciate or not. You may not elect to claim it; but IRS will assume you take it if it's a business with depreciating asset.

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      • #4
        JacobC is only half correct about the tax rate arbitrage being the advantage. The other is the time value of money.

        In his example, you saved $10,800 in taxes, but you invested that money @ 7%, so you now have $15,481 to pay that $9,000 tax bill.

        (Warning: Tax policy can change, but this is currently accurate.)
        Also, you can 1031 exchange that first property into a second property, and thus you avoid paying capital gains at all as you change investments. Further, if you die, your heirs get a step up in basis, so they never pay back that depreciation recapture.

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        • #5
          When you buy an asset, a building for example, your purchase price plus any transaction costs is considered your cost basis or simply your basis.

          When you take depreciation deductions on the asset it reduces your basis and this reduced basis is called your adjusted basis.

          When you sell an asset, your gain is the difference between the selling price and the adjusted basis.

          When determining your adjusted basis you use the greater of the allowed or allowable depreciation.

          Allowed means what you actually deducted and allowable means what you could have deducted.

          If you don't claim depreciation expense your gain on the sale is calculated as if you had taken it. If you miss it early on you can do an accounting method change to catch up.

          Depreciating the property provides two benefits -

          More deductions sooner
          A deduction at a higher rate than the subsequent gain

          Regarding the more deductions sooner, you get a deduction now and while recognizing more later. From a time value of money point of view this is a good thing. There are scenarios where this doesn't benefit you so it's not always a good thing.

          The gain attributed to prior depreciation of real estate is called "unrecaptured §1250 gain" and is a type of capital gain. Like other long-term capital gains it has a preferred rate that depends on your other sources of income. See §1(h).

          The maximum rate on unrecaptured §1250 gain is 25%. So as a high earner you will have received a tax benefit of 37% for the depreciation deductions while creating a corresponding gain of 25%. This results in a 12% spread.

          Here's an example -

          Purchase rental real estate on January 1st in Year 1 for $200,000. The cost of the building is $150,000 and the cost of the land is $50,000.

          Year 1 depreciation is $5,227
          Year 2 depreciation is $5,455
          Year 3 depreciation is $5,455

          You sell the property in July of Year 4 for $250,000

          This makes your Year 4 depreciation $2,955

          And total accumulated depreciation $19,092

          Your adjusted basis is $180,908 which results in a $69,092 gain.

          Of this gain, $19,092 is unrecaptured §1250 gain and $50,000 is long-term capital gain (aka §1231 gain)

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          • #6
            The tax advantages of real estate are many. There is regular depreciation, then there is bonus depreciation, then 1031 exchanges, and write offs at regular income tax rates, with subsequent payments at capital gains rates. There is also REPS, or real estate professional status. If you or your spouse qualify for REPS, you can use real estate phantom depreciation losses to avoid paying taxes on your medical income. Of course, the real estate investments have to be wise investments to start with, but if they represent good investments, then the tax advantages can juice the returns in a very substantial fashion.

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            • #7
              Originally posted by DavidGlennCPA View Post
              When you buy an asset, a building for example, your purchase price plus any transaction costs is considered your cost basis or simply your basis.

              When you take depreciation deductions on the asset it reduces your basis and this reduced basis is called your adjusted basis.

              When you sell an asset, your gain is the difference between the selling price and the adjusted basis.

              When determining your adjusted basis you use the greater of the allowed or allowable depreciation.

              Allowed means what you actually deducted and allowable means what you could have deducted.

              If you don't claim depreciation expense your gain on the sale is calculated as if you had taken it. If you miss it early on you can do an accounting method change to catch up.

              Depreciating the property provides two benefits -

              More deductions sooner
              A deduction at a higher rate than the subsequent gain

              Regarding the more deductions sooner, you get a deduction now and while recognizing more later. From a time value of money point of view this is a good thing. There are scenarios where this doesn't benefit you so it's not always a good thing.

              The gain attributed to prior depreciation of real estate is called "unrecaptured §1250 gain" and is a type of capital gain. Like other long-term capital gains it has a preferred rate that depends on your other sources of income. See §1(h).

              The maximum rate on unrecaptured §1250 gain is 25%. So as a high earner you will have received a tax benefit of 37% for the depreciation deductions while creating a corresponding gain of 25%. This results in a 12% spread.

              Here's an example -

              Purchase rental real estate on January 1st in Year 1 for $200,000. The cost of the building is $150,000 and the cost of the land is $50,000.

              Year 1 depreciation is $5,227
              Year 2 depreciation is $5,455
              Year 3 depreciation is $5,455

              You sell the property in July of Year 4 for $250,000

              This makes your Year 4 depreciation $2,955

              And total accumulated depreciation $19,092

              Your adjusted basis is $180,908 which results in a $69,092 gain.

              Of this gain, $19,092 is unrecaptured §1250 gain and $50,000 is long-term capital gain (aka §1231 gain)
              How the heck did you have time to work all that out in mid-February?!?
              Our passion is protecting clients and others from predatory advisors. Fox & Co CPAs, Fox & Co Wealth Mgmt. 270-247-6087

              Comment


              • #8
                Originally posted by StarTrekDoc View Post
                +1 JacobC -- to add-- there's no choosing to depreciate or not. You may not elect to claim it; but IRS will assume you take it if it's a business with depreciating asset.
                I have seen many instances where people make this mistake. My FIL even had his CPA recommend that he not take the depreciation because he'd have to recapture it eventually (which made my head spin and me recommend he find a new CPA). Whether you take it or not, you will be paying tax on the recapture when you sell it (unless doing a 1031), so there is absolutely no reason not to, and in fact it's a major financial mistake to not write off the depreciation. Even if it were optional, there would be no reason not to take a non-cash expense today just because you may have to pay today's taxes several years down the road.

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