Investing in rental properties comes with a lot of benefits. Most investors choose the option because of the assurance that they will have a fixed cash flow even when a tenant leaves the property. It is like a recurring income. The potential here is relatively long-term and comes with multiple tax benefits.
One significant tax benefit of investing in rental property is the use of the depreciation expense, which can help reduce the taxable income. Further, the other advantage can be accelerated depreciation. In some cases, the investors have an option to accelerate the depreciation to generate loss even when they enter properties with positive net income.
Despite the advantages of rental properties, most investors still have no idea how to invest or why they must consider the option, especially after the current market scenario. Mentioned here are the details about the residential depreciation and how you can significantly reduce a tax by using the accelerated depreciation on the rental property.
Accelerated depreciation on rental property- What is it?
In simple terms, depreciation is the annual deduction from the pretax net income, which will allow the real estate investors to recover the cost of the real estate properties during the phase where the investor owns the property.
Compensation for property deterioration, wear and tear, and obsolescence is a great way of thinking about depreciation.
For calculating the depreciation, the cost basis includes the property purchase price from which the land value or lot is reduced. In addition to the cost that is to be capitalized like, the capital expense for closing costs of replacing a roof is further added to the basics like recording fees or title insurance.
The residential property has been appreciated for over 27.5 years. Herein the depreciation expenses spread evenly over time. Some components of the rental property like flooring, appliance, landscaping, and fencing. They depreciate entirely during the first few years.
By making use of the accelerated depreciation, the investors have the option to reduce the pretext income to a great extent during the first few years. But before you continue, it is worth noting that depreciation does not necessarily mean that entering the property will become less valuable for the owner in case of sale. In fact, during the selling process, the depreciation clocks get a reset.
A well-maintained enter property no doubt will bring in a significant cash flow year after year as there will be annual the cell price of the houses sold will increase over an extended period.
Depreciation of rental property
The straight-line depreciation method is used to depreciate the rental property by the same amount every year. The residential investment property generally declined over 27.5 years. So if the cost of the rental property is about $110,000, then the owner is liable to reduce $4000 per year from the pretax income for all those 27.5 years.
With the use of the cost segregation study, the investors can access the cost basis of the rental property and understand the components for generating more of the paper loss during the first few ownership years.
Here is an example that will clearly explain accelerated depreciation on the rental property, its impact on the pretext income compared to straight-line depreciation, and also the working.
Let’s consider,
- $120,000 as a property purchase price
- $10000 as land value
- $2000 closing cost, which is added to the cost
- $7000 as appliance and flooring value
- $1000 as fencing value
The cost basis of the property for depreciation purposes will come to around $112,000 and will the identified by reducing the purchase price and land value and adding closing cost, which is to be included in the cost basis. To determine the items that can be depreciated more quickly and their value, the owner has the right to perform a cost segregation study. For example, the flooring, appliances, etc., will depreciate over five years, while the fencing value will depreciate over 15 years. Now let’s look at how accelerated depreciation will increase the total expense, and the owner in this scenario can claim the benefits.
Pretax income can be identified by reducing the mortgage interest and operating expenses from the total rent income collected.
In addition, the property cost basis for accelerated depreciation is identified by reducing the appliance value, fans, and flooring from the entire cost basis of $112000.
Using the isolated depreciation, the investors can claim the loss for the tax purpose. It will come to around $369 per year.
The loss herein can be used for offsetting the profit from the other investments of the current tax year, or even the loan can be carried and used as a deduction in the future tax years until the conclusion is finally used up.
Bonus depreciation
Investors have the right to claim about 100% bonus depreciation on some of the properties, which generally can be depreciated over 5, 7, or 15 years. The bonus depreciation can be applied to the property placed into service after September 2017 and before 1st January 2023. After the year 2023, the bonus depreciation percent of the investors can decrease by 20% each year until 2027. After that, it is the time at which the benefits will expire.
When you claim bonus depreciation, the investor’s front-load minimization can be done to reduce taxable net income even more. In addition, the bonus depreciation is a one-time benefit, so after the first year, the annual depreciation expense will be reduced as a flooring, appliance, or fencing will fully depreciate.
Rental property accelerated depreciation pros and cons.
A significant advantage of accelerating depreciation is reducing the investor’s taxable net income. The paper loss, created by depreciation, can be used to offset other profits in the same tax year, like dividend income received from a private REIT or the net income accumulated from other rental properties present in a portfolio of the investor.
Any of the remaining loss is to be carried forward into the future taxes and then must be used to offset future gains until the total loss is exhausted.
A disadvantage of accelerated depreciation is that the investor will have to spend money on a cost segregation study to identify the items with faster depreciation. Another disadvantage is that it is taxed and recaptured when the rental property is sold.
The maximum tax that can be recaptured on depreciation is about 25%, while the total tax on the capital gains will come to around 20% based on the investor’s income tax bracket.
But the good news is that depreciation and capital gains recapture tax can be deferred by conducting a 1031 exchange. There are multiple rules the Internal Revenue Service has established for 1031 tax-deferred exchange.
This can include strict time frames for purchasing and identifying the replacement property. Also, the replacement property price or any other mortgage balance must be equal to or greater than the relinquished property to avoid incurring capital gain tax liability.
When planning to use the 1031 exchange, you might need to consult the tax advisor to ensure you follow the correct process.
Rental property depreciation
Manual tracking the depreciation, bonus depreciation, accelerated depreciation, and capital gains can be quite complicated even when you just got one property. No doubt you could have a separate spreadsheet for tracking the depreciation.
But there are platforms and applications available where you can sign up for free and have the benefit of automatically tracking the rental property depreciation. The real estate balance sheet on the platform keeps tracking the depreciation expenses. Also, it automatically updates the mortgage balance and property value to give you a more accurate idea of the equity.
Once you link your mortgage account and the business banking accounts, the platform will be able to track the expenses and income in real-time automatically. Also, the rental property on it will have an option for monitoring all the investments from a single online dashboard. This will help them make informed decisions for optimizing returns.
Conclusion
When you choose to go for accelerated depreciation, it will work well for investors who want to have more cash during the start. For upgrading, they aim to purchase an additional rental property. But before you decide or accelerate the position, it will be better for you to talk with a financial advisor.
If you need professional assistance, you can contact Private Capital Investors. They have the best professionals to help you with the entire process. No matter what you are planning for, the professionals are skilled. They will assure you get all the help and assistance you need to guarantee your investment is safe and you can make the most of it.
