Cost Recovery (Depreciation) and Recapture Taxes
One of the more significant benefits of investing in income-producing real estate is the ability to decrease the tax obligation on the income produced through depreciation. This is also known as cost recovery, as Depreciation is defined as the recovery of the acquisition costs of IRS Section 1231 tangible assets (such as real and personal property).
The implications of cost recovery, capital gains and 1031 exchange cost recovery should be carefully considered by real estate investors. When a property is purchased a tax basis is allocated to the depreciable and non depreciable portions; the depreciable portion being the building (improvements), the non-depreciable portion, the land. In the tax records there is usually a percentage of the property assigned to improvements (meaning the building) which is the depreciable portion; however these records are frequently inaccurate and must be verified. Once the correct percentage of the property is identified, a depreciable tax basis can be calculated by multiplying the percentage given and the purchase price of the asset, i.e. Purchase Price: $1,000,000. Percentage of Improvements: 75%. Tax Basis: $750,000.
Depreciating an asset reduces the taxable income and increases after tax cash flow. Theoretically, the depreciation corresponds with the amount of expected wear and tear and potential obsolescence during the tax life of a property, presumably making the tax basis in the property at the time of disposition equal to the market value of the property at the time of sale
There are different methods used to depreciate a property, one of which will be designated at the time of the purchase. The straight line cost recovery method is the only method available for “real” property placed in service at this time. According to this method commercial properties are given a 39 year tax life by the IRS and residential properties (apartment buildings included) are given a 27.5 year tax life, meaning you can divide the depreciable tax basis by either 39 or 27.5 and deduct the result from your ordinary income each year, until the property is fully depreciated”. i.e. $750,000 divided by 39 years = $19,230 per year that can be deducted from ordinary income.
The Tax Relief Act of 1997 made changes to the taxation of improved commercial and investment real estate. For properties sold after May 6 1997, a non corporate taxpayer will be required to “recapture”, or pay taxes on any straight-line cost recovery (depreciation) taken during the holding period of the asset. This is accomplished by the property owner paying back a maximum of 25% of the depreciation (tax relief) to be taken at the time of disposition of the depreciated asset. Recapture taxes are paid in addition to and before capital gains taxes and, like capital gains taxes, can be deferred in a 1031 exchange. Due to the unique nature of each taxpayer’s situation, a detailed discussion of this subject with a tax professional is extremely important.
Cost Segregation depreciation should also be considered. This form of depreciation allows a property owner to divide a building into components, depreciating portions of the “building” separately. Many of these “components” are most likely eligible for a shorter tax life (and considered “personal property”) allowing for larger amounts of depreciation sooner (accelerated depreciation) and effectively increasing an investor’s after tax cash flow even more.
Examples of these components are the roof, the HVAC system, window coverings, etc. Cost Recovery (depreciation) must be reviewed with the investor’s tax professional to insure accuracy and to fully understand the potential tax implications and benefits.