Depreciation is a double-edged sword. It’s a big part of why real estate works so well with leverage as an investment. Taking the depreciation allowance on investment property is a critical part of the attractiveness of real estate investing, from the point of view of the cash-flow investor. But the rules governing depreciation are notoriously baffling, and occasionally trip up even tax professionals.
With tax time on the horizon, here are some tips on depreciation for real estate investors There are lots of articles out there explaining the basics of depreciation and amortization, but the best of them is still the IRS publication on How to Depreciate Property.
There are fewer articles out there that specifically outline some of the traps and landmines that surround depreciation and give the property owner some concrete tips on how to avoid them. So I decided to put some tips together here:
1. The “Use it or Lose It” rule is in effect! You must be on the ball when it comes to claiming allowed depreciation each year. This is because if you neglect to claim depreciation in one year, you cannot “double it up” in the following year to catch up. You may be able to file an extended return, but if you’ve made the same mistake two or more years in a row, and it was because you chose the wrong method, rather than a simple math error, you might have to file for a change in accounting method, using IRS Form 3115.
Furthermore, when you sell a property, the IRS will force you to subtract all allowable depreciation from your basis, and calculate capital gains taxes based on that, even if you did not claim the depreciation!
Think that hurts? Here’s another twist of the knife: If the IRS recaptures depreciation in this way, the amount recaptured is not taxed at capital gains rates, but at ordinary income rates.
2. The Section 179 deduction and accelerated depreciation is nice – but remember that it doesn’t count for real estate. Real property is not eligible for Section 179 deduction. Your real estate transactions have to make sense even if you don’t get much in the way of first-year deductions.
3. Be careful with taking big Section 179 deductions if you are the owner or part-owner of a fiscal year corporation or partnership. Yes, the corporation can deduct up to $500,000 in equipment. But currently, owners can’t take advantage of the full amount in practice. They can only deduct $25,000 of anything that flows through a K-1 report in tax years beginning after 2013.
4. Tax year 2013 is the last year for bonus depreciation under Section 179.
5. Remember that land doesn’t depreciate. Just the building. So you have to separate out the value of the building from the land. Generally, the IRS will accept your local property assessor’s judgment, so you can use that document to back up your own calculations.
6. Land doesn’t depreciate. But landscaping does!
7. Did you plant anything on investment property? That’s depreciable over 15 years, under MACRS rules. Fruit and nut-bearing trees are 10-year property.
8. Spouses are not depreciable. But livestock is!
9. Don’t forget: If you’ve made improvements or renovations to an investment property, you can keep depreciating the cost of those improvements even after you have already fully depreciated the original cost of the home.
10. Try to get your renovations done and property into rentable service, or capital equipment into use prior to the last quarter of the year. This helps you avoid or minimize the negative impact of the mid-quarter convention. This is a special tax rule that applies if the IRS notices you crammed at least 40 percent of your depreciable property into service in the last quarter of the year. This is their way of keeping you honest and preventing you from claiming six months’ worth of depreciation on assets you place in service in the last few days of the year.
11. You can’t claim depreciation on your personal residence. You do get an exemption from capital gains taxes, though, ($250,000 for singles or $500,000 for married couples) if you meet the ownership and use tests.
12. Do you have a home office? It depreciates under a different schedule than ordinary residential property. The portion of your home committed to business use is depreciated like commercial property, not residential property. This means that it uses a 39-year depreciation schedule, rather than a 27.5-year schedule.
Heads-up: If you have been claiming a home office deduction, and then you sell your home, you will probably get smacked with something called the depreciation recapture tax. You can defer that tax by using Section 1031 like-kind exchanges, but it is very difficult to avoid it altogether. Note that even if you never claimed the depreciation, the IRS will still tax you as if you had!