Real estate is a potentially lucrative investment. If you’re like many investors, you might not be fully aware of the options available for increasing financial gains over the term of property ownership. Owning real estate can shelter some of your money from income taxes unless you lease it out. However, your investment also becomes a tax deduction.
Though you might know that you can take deductions for your investment property’s depreciating value, did you know you can use accelerated depreciation to increase your deduction? At Reef Point, we’re committed to ensuring real estate investors get the most out of their investments. Let’s go over how to lower your taxes even further, using depreciation to your advantage, and then how to avoid paying a significant tax bill when you sell the property.
What Is Accelerated Depreciation?
Any time you purchase an investment property, you can use its depreciated value to lower your annual taxes. However, some elements of a house decline faster than others. Using accelerated depreciation in real estate allows you to increase your tax deduction based on the quicker loss of value for these elements.
Normally, you calculate your deduction based on the depreciation rate of the property’s structure over 27.5 years for residential real estate and 39 years for commercial property. However, a house’s flooring, appliances, fixtures and other components have a shorter life span and thus depreciate faster than the structure. If you account for this faster depreciation, you can take a higher deduction in the first years you own the property. This strategy is most often used for rental properties.
Cost Segregation
To maximize the tax benefits and ensure you adhere to the Internal Revenue Service’s requirements for using accelerated depreciation, you will need to hire qualified professionals to conduct a cost segregation study. The process involves assessing the property to divide components into depreciation categories of five, seven and 15 years. The study’s results determine the accelerated depreciation deductions you can take on your taxes.
What Are the Benefits of Accelerated Depreciation?
Taking advantage of faster depreciation rates when calculating your tax deductions on investment property has three primary benefits.
1. Lower Investment Costs Up Front
Real estate investments come with substantial up-front costs, especially if you intend to use it as a rental property. If you take advantage of accelerated depreciation for real estate, the additional deductions reduce the initial financial hit you take when purchasing a property and readying it for rental. The tax savings potentially increase your initial profit margins, allowing you to reinvest in the business, invest in other vehicles or use it as you see fit.
2. Increased Deductions in the Early Years
The greatest tax savings occur in the first year you use this strategy. However, you will continue to see increased deductions over subsequent years. These savings help offset your initial investment and free up more of your cash for personal use or other investments, allowing you to make your money work harder for you.
3. Increased Tax Liability Control
Accelerated depreciation provides a short-term tax advantage, and using the strategy gives you more control over when and how much you pay in taxes each year. This added control lets you balance personal and business financial needs and your annual tax liability.
Which Accelerated Depreciation Method Should You Use for Real Estate?
There are two common accelerated depreciation methods real estate investors use. The most popular is the double-declining balance model. The DDB method doubles the depreciation deduction for qualified assets over the amount you could take using a straight-line deduction on those assets, which lowers the deduction amounts over time and cuts the number of years you can take the deduction.
The second approach is the sum of the years’ digits. This method entails summing the numbers for the expected life of an asset. Calculating the digits of an asset with a 10-year life expectancy requires adding the digits one through 10, resulting in a sum of 55. Each year, you would calculate the depreciation deduction by dividing the years left of the asset’s life by the sum of digits. In this example, year one’s depreciation value would be 10/55; in year 10, it would be 1/55.
What Is Depreciation Recapture?
Accelerated depreciation lets you lower your tax burden when you can take the deduction. However, the IRS will eventually recapture those taxes. Any time you sell an asset that you took depreciation deductions for, the IRS considers these deductions as a decrease in asset value, resulting in higher capital gains. Using accelerated depreciation causes a more significant reduction in the IRS’s calculation of the property’s value, which means even higher capital gains than the straight-line depreciation method.
Can You Defer Capital Gains Taxes?
Fortunately, you can sell your investment property without immediately paying those higher capital gains taxes on the profits. One common tax deferment route is a 1031 exchange. If you sell your property and reinvest it into a like-kind property using a qualifying 1031 exchange, you won’t pay capital gains taxes until you decide to sell your property without participating in an exchange.
However, another option — and a 1031 exchange exit strategy — is to create a deferred sales trust. Utilizing a DST lets you defer capital gains taxes, potentially reducing your overall taxes and providing an income stream. To take advantage of this strategy, you need to connect with a certified DST trustee, such as Reef Point’s Gregory Reese, before you sell the property to set up the trust and establish its terms.
Before closing, you transfer your rights to the trust, and the profits from the sale go to the trust. At the agreed-upon time, you begin receiving a monthly payment from the trust in the amount set in the trust’s terms. You only pay capital gains taxes on the payments you receive in any given year.
Extend the Benefits of Depreciation With a DST
Taking advantage of accelerated depreciation for real estate investments certainly has its benefits. However, when the time for selling the property arrives, you may face significant taxes. Let Reef Point help you continue to reap the benefits of depreciation using a deferred sales trust when you’re ready to offload the property. Contact us today to learn more about DSTs and our services.
Sources:
https://www.irs.gov/publications/p946#en_US_2022_publink1000107337