I realize this totally makes me a nerd, but I think I have a favorite tax break – Depreciation of rental property.  Most tax breaks, like charitable contributions or mortgage interest require you to spend money to get a tax break.  For instance, you might give $10K to charity, and if your marginal tax rate is 40%, you then get a tax deduction of $4K.  Obviously spending $10K to save $4K is a losing business proposition.  Depreciation isn’t like that.

Why Depreciation of Rental Property is My Favorite Tax Break

The Rules of Depreciation

Your rental property is depreciated over 27.5 years.  So each year when you do your taxes you take the value of your property when you bought it and divide it by 27.5.   That amount is then subtracted from your rental property income.

So if you spent $200K on a rental property and it rents for $18K a year (let’s say $10K after expenses), then you get to subtract $200K/27.5 = $7273 off that rent.  Now you only have to pay taxes on $2727 of income instead of $10K.  If your marginal tax rate is 40%, that’s like $2909 back in your pocket.

It’s even better if you’re not a high earner since you can actually deduct a real estate loss against your regular income, but most doctors won’t be able to do that as this deduction phases out at an AGI between $100 and $150K.

Adding To Basis

But wait, it gets better.  Any capital improvements you made to your rental property gets added on to the basis (original value.)  Examples of capital improvements include putting on a new roof, paving the driveway, building an addition, or installing air conditioning.  You can also include casualty losses, legal fees, and the costs of restoring damaged property.  This increases your basis, which is a good thing not only because you can then depreciate based on the increased basis, but you also owe less in capital gains taxes when you go to sell (since you owe tax on the difference between the value and the basis.)

What About Depreciation Recapture Taxes?

Critics in the know will quickly respond that depreciation must be recaptured when you sell the property.  This is true.  It is also unfortunate that it is recaptured at 25% (see explanation in addendum below) rather than the lower capital gains tax rate.  But just like with a 401K, it is possible that you saved taxes at a higher rate during your working years and then paid it at a lower rate during retirement.  Of course, the reverse is also possible, so it is a good idea to see if you can’t avoid paying depreciation recapture taxes at all.

Avoiding Depreciation Recapture Taxes

Depreciation recapture taxes can be avoided for decades in two ways.  First, you don’t have to pay them until you sell.  Don’t want to pay them?  Don’t sell.  Second, even if you want to sell, as long as you buy another investment property, you can defer paying the taxes by doing a Section 1031 exchange.  As mentioned in a previous post, it’s possible that depreciation recapture taxes won’t have to be paid at all if you die without selling, convert the rental (or one you exchange into) into a personal residence prior to selling, or if you donate the property to charity either outright or via a charitable remainder trust (which gives you income til death, then the “remainder” goes to the charity.)

An Example

So let’s say Joe buys a $200K property.  He owns it for 10 years (now worth $300K) before exchanging it for a $400K property.  10 years after that, he exchanges that property (now worth $600K) into a $1M property.  He dies 10 years later, leaving the investment now worth $1.5M to his son.  His marginal tax rate was 40%.  How much money did he save in taxes thanks to depreciation?  $233K over 30 years.  His son also gets to save the taxes due on the $800K in appreciation thanks to the step-up in basis at death, which assuming the son has the same 40% marginal rate, is another $320K in tax savings.  But even if the owner stupidly sold the property prior to his death and paid the depreciation recapture taxes (not to mention the capital gains taxes), he still had the benefit of 40 years of using that deferred tax money for consumption or investment.  In real estate investing, cash is king, and depreciation provides cash in the early years when it is most useful.

Free Money

The reason for the depreciation tax break is because stuff gets old and worn out.  But in investment real estate, only the building gets old and worn out.  The land itself will hold its value and likely appreciate at around the rate of inflation.  Not to mention most houses and apartment buildings last far longer than 27.5 years.  So the depreciation is mostly theoretical, especially if you make occasional exchanges for updated properties.  Rather than getting a tax break for money you actually spent (like taxes, mortgage interest, or repairs), you’re getting a tax break for nothing.  Who doesn’t like free money?

Addendum/Correction:

In case it wasn’t clear above, you cannot depreciate the value of the land, only the value of the building.  Also, depreciation recapture is paid at a flat 25%, NOT YOUR MARGINAL RATE (see line 30 of the Schedule D Tax Worksheet found in the Schedule D instructions).  This can be extra valuable for a high earner.  You may get the depreciation tax break at 33% or more, but then only pay depreciation recapture at 25%.  Of course, you’d be best off not paying depreciation recapture at all by exchanging the property (or dying with it.)

One other consideration is that the ratio of the value of the building to the value of the land need not remain constant.  Consider a property worth $200K where the value of the building is 50% and the value of the land is 50%, or $100K each.  You depreciate the building at $100K/27.5 = $3636 a year.  Let’s say you own it for 10 years, so you’ve depreciated $36,360.  Now, the property is worth $300K.  If you assume the same ratio, the building is now worth $150K and the property is now worth $150K.  You pay 25% on $36,360 of gain, and 15%  on $100K of gain for a total of $24,090 in tax.  But what if the property is now worth $300K, but the actual building depreciated 20% (meaning the land appreciated from $100K to $220K)?  Then you’d only have to pay 25% on $16,360, and 15% on $120K, or $22,090.  You’d better have a pretty good argument waiting for the IRS if you get audited pulling this stunt, but those arguments may very well exist for your property.