You land in Vegas and check into your hotel on the strip ready for the night ahead. Hitting the casino floor you play a few hands of blackjack, have a drink, meet up with friends, and grab a taxi to a show, where you have another drink—at which point you’re feeling good. The show ends, the night’s young, and besides it’s Vegas, so you head to a club. At this point you’re having a great time and feeling smart, attractive, and invincible. You talk about buying that bar back home with your buddies after you steal Vegas’ money at the poker tables. As you plan your takeover of the world, against your better judgment, you have more drinks and the night gets blurry. The question is—you know you’re going to have to pay for that the next day (or longer), right? Many don’t know this when it comes to depreciation, but the scenario really isn’t all that different.
The Origins of Depreciation
In its simplest form, depreciation is the recognition that many assets have a limited lifespan. They wear out (real estate without ongoing maintenance) or suffer from obsolescence (an outdated computer). Today, most property is depreciated based on a small number of recovery periods, known as the useful life. Periods vary from asset to asset, but for commercial real estate the timeframe is set at 39 years, residential real estate is spread over 27.5 years, and leasehold improvements are at 15 years. Some items, like land, are not depreciable, because they are assumed to be free from deterioration or obsolescence.
Feel Smart and Attractive
Many investors, accountants, and commercial real estate professionals speak in glowing terms about the tax benefits of owning investment or commercial real estate. Without question, one of the terrific advantages of ownership is the ability to take advantage of depreciation. Depreciation is calculated on your taxable basis, which is generally equal to the acquisition price of the real estate, less land, plus the cost of any capital improvements made to the property before it was placed in service.
For example, if your basis on a commercial structure is $750,000, placed on a 39-year schedule, the annualized depreciation allowance is approximately $19,231. This allowance is a form “straight-line” depreciation and results in a fairly nice deduction and less tax liability, which makes you feel smart and attractive. Sometimes, the Internal Revenue Service lets you front-load the depreciation and take more up front and less (or none) at the end. The concept known as bonus or accelerated depreciation produces higher deductions and greater tax savings for a period of time. The enhanced tax savings can make you feel smart, attract, and invincible…until they end.
The Next Morning
Not unlike Vegas, the consequences of the good times are not fully understood, or easily enough forgotten, in the moment. Depreciation is meant to simulate an asset’s gradual loss of value over time. What is often forgotten or not known at all is the taxable benefits aren’t a gift, they’re a loan. The IRS will want its money back and it gets it in the form of a depreciation recapture tax.
When a real estate investment is sold for a profit, capital gains taxes are due on the profit. If it’s sold for more than the depreciated value, there is also a 25% recapture tax. Other types of assets are subject to depreciation recapture tax at your regular income tax rate.
A healthy profit on the back of the napkin can quickly become less appealing after the tax liability is considered. As an aside, even if you don’t take depreciation, you’re still subject to recapture because it was available to you. Regardless, even though payment is generally due upon recapture, there is benefit from using the savings today and paying the IRS back in the future with less valuable money.
Payment, Death, or Deferral?
You always have the option of paying your taxes, but if you want the good times to keep going–there are two alternatives. Technically, depreciation recapture is a type of capital gain, so you can avoid or defer it like any other capital gain. The first way is to have your assets stepped up in basis through death, which admittedly isn’t ideal. The second is to do a 1031 Tax Deferred Exchange and carry the basis forward (for more information, see: www.timreamer.com/1031ex). While you’ll have to follow stringent rules to defer taxes and depreciation recapture through an exchange, it is easier than the day after the Vegas scenario—just don’t expect anyone at a party to ask you to tell the story of the time you avoided depreciation recapture.
Tim Reamer provides commercial real estate brokerage and consulting services with Cottonwood Commercial and specializes in investment property (multifamily | commercial | NNN), retail/restaurant site selection, and commercial buyer/tenant representation. Learn more at www.timreamer.com.SHARE