Among the least understood tax benefits of rental properties, real estate depreciation is also one of the greatest.
Want to be one of the few landlords who understand it?
Deni and Brian break down how depreciation works, how to calculate it, and how it get prorated in the first year you buy a rental property. Then they explain depreciation recapture — and how to avoid paying it.
Finally, they point you toward SparkRental’s free rental property depreciation calculator, to make life even easier for you as a landlord!
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Deni Supplee: Hi everyone, and welcome to our weekly broadcast and podcast. Last week, we all we talked about it was Thanksgiving, so we talked a little bit about a lot about the science of gratitude and success. And that’s one of my favorite topics. And this week, Brian is going to talk to us more than I will about how rental property appreciation works. And he created an awesome calculator. I was messing around with it before we came on today. And so go for it, Brian. Start us off.
Brian Davis: All right. Well, you know, I’m going to start by giving a little disclosure here that I am not an accountant, I’m not a tax attorney or even a tax expert. But we are going to walk through the basics of depreciation and what you need to know about it as a real estate investor, because it’s one of the least understood tax benefits of rental properties and a lot of landlords don’t take advantage of it. So first of all, you can depreciate the value of the building, but not the land, so. The way this works is that you buy a property, let’s say you spend one hundred fifty thousand dollars on a rental property, of that one hundred thousand is the building. Fifty thousand is the land. So that one hundred thousand that the building is valued at, that you can deduct over the course of 27 and a half years is what the IRS allows. So you can take a deduction every year. One 27 sand a half of the value of the building when you buy it. Now there are some other costs you can add in there and also depreciate alongside the purchase value of the building. Most closing costs you can depreciate as a real estate investor. You can also depreciate capital improvements that extend the lifespan of the building or improve the value of the building.
Deni Supplee: And things like adding a room.
Brian Davis: Yeah, a new roof. If you go out and replace all the windows to upgrade them, you replace the heating system or replace all the plumbing, you know, any of the mechanical systems, anything that extends the usable lifespan of the building, you can depreciate along with the value of the building itself. So following that example, you buy a property for one $150.000,00. So $50.000,00 of that is valued at the land. $100.000,00 that is valued for the building. So you can divide that $100.000,00 for the building over 27 and a half years, and there will be right through next year. And then that’s what you can deduct each year. So in that particular example, that would be $3.636,00 every year. You can deduct from your taxable income for depreciation. Now that is except for the first year which is prorated and the last year, which you have a half year on. And, you know, there may not even the 28th year, you may not be able to deduct anything for depreciation if you bought the property earlier than halfway through the first year. So, you know, it gets a little mind bending there. But we did create a free rental property depreciation calculator to make this way easier for you guys, which you can use. So we’re going to put a link to that in the comments here. And we’ve got our first question here from Sandeep. He says, I bought a property in 2020 and also refinanced the same property in 2020.
Brian Davis: Well, should I appreciate all closing costs over 27 and a half years or deduct from income? So send some closing costs you can deduct immediately as same year deductions, some closing costs. You have to depreciate now which ones fall under which category you’re going to have to speak with an accountant about. We can’t get into all that here. Even if I knew all the answers to that over the integrity with which I can’t say that I do so. So, yeah, the answer is it depends on the closing costs. Some you can depreciate over the twenty seven and half years, some you can deduct immediately for this year.
Brian Davis: And Tim Toohey says love this topic. Thank you so much. Thank you Tim. We always love seeing it in terms of regular. All right.
Brian Davis: So let’s let’s talk for a second here about depreciation recapture. So when you sell the rental property, you have to pay back the money that you deducted to the IRS. Not in so many, not exactly what you what you deducted, but any money that you deducted that will be taxed at your regular income tax rate when you go to sell the property. Now, that is capped at 25%, however, whereas currently the highest federal tax income rate is 37%. So you are if you’re at the higher income tax rate, there is a cap on this. So there is still a tax benefit there. But even if there weren’t, there is still a tax benefit because it delays you having to pay taxes. So it’s in some ways it’s a free loan from the IRS is one way of thinking about it, which is always worth doing, because then you can use that money and invest it in the return on it. But, you know, even if that weren’t the case, you can still avoid the depreciation recapture by avoiding capital gains tax on the real estate.
Brian Davis: Now, like we just said, depreciation recapture is not taxed at the lower capital gains tax rate. It is taxed at your normal income tax rate, capped at twenty five percent. But you can still avoid paying depreciation recapture through the same kinds of tactics that you use to avoid paying capital gains taxes. Classic example being 10, 31 exchanges. But, you know, you can you can use all kinds of tactics to avoid paying capital gains taxes on real estate. You know, for example, you. And keep the property indefinitely as a rental and just keep refinancing it every time you pay it off, you can just keep pulling the money out and then letting your tenants pay down that mortgage for you again and then keep it until you die. Right. And pass it on to your children. And at that point, it becomes part of your estate. And the first but it’s something like $5.500.000,00 of your estate is tax free at this point, is exempt from from estate taxes. So there are all kinds of things you can do to avoid and minimize capital gains taxes. And that’s a whole nother topic in itself, which is which we should actually we should do that soon. We should go through that soon.
Deni Supplee: To our full disclosure, this is complicated stuff and do to get your full maximum value. You want to contact not only just an accountant, but you want to you want somebody who knows real estate like the back of their hand.
Brian Davis: Absolutely. Yeah. This depreciation does get complicated quickly. The one one point that’s worth mentioning here, we mentioned that the first year when you buy the property, that the depreciation is prorated, it’s prorated by month. So it’s on one month intervals. So when you go in and use that rental property depreciation calculator, you’ll actually see there’s a selection there. You can select which month you bought the property in and then it will tell you exactly how much you can depreciate in that first year, because that is going to be different than the subsequent years, which are, you know, the full year depreciation instead of just the partial year’s depreciation. But that is divvied up by month, not by day, not by quarter. So that’s a tip there if you have bought a property this year.
Deni Supplee: That’s awesome, and it’s fun. I was messing around with it, actually opened my eyes to this whole subject, which I like to close my eyes for.
Brian Davis: Well, and you’re not alone in that.
Brian Davis: So many landlords find the whole concept of depreciation so confusing that they just ignore it and don’t worry about it and don’t hassle with it. But they end up giving up some extra cash flow that they could be earning on their property for twenty seven and a half years. It does improve your cash flow by helping you reduce your taxable income. It’s a paper expense that you can write off. So in many cases, landlords will show a loss on their rental properties even though they actually made money in real life. So it’s a it’s a paper expense and it does it improves your cash flow by lowering the amount of taxes you have to pay each year. And then you can use that savings to just snowball your income even further by by funneling those savings back into income producing investments like new rental properties or stocks or shares in Arete or whatever it is. All right. All right. We’re going to keep this one super short and sweet today. Do you have any last comments before we wrap things up?
Deni Supplee: No, just as you guys are listening to this, you’re watching this or listening to our podcast, if you could give us a review. Also, let us have some feedback and let us know what you think or if you have any subjects that you would like us to cover, throw them our way.
Brian Davis: Absolutely. And we do have a coming here from Sundeep. He says a depreciating my property for 12 years and then did a 10 30 one exchange, which gave me even more savings with a giant smiley face there. So it’s definitely something to smile about. And people are learning from you. Yeah, right.
Brian Davis: I mean, and that is one of the beautiful things about investing in real estate is all the tax advantages you can go out and you can keep snowballing your portfolio of properties and keep funneling all of these tax savings back into the portfolio to keep growing it even faster and to eventually build enough passive income that you don’t have to work anymore. Which is which is what Deni and I are all about, financial independence with real estate.
Deni Supplee: And he gave us a shout out and he loves every Tuesday at 2:00 p.m.. Thank you.
Brian Davis: Well, why don’t we love that you join us every Tuesday at 2:00. So thanks for joining us and thanks for the comment. On that note, we’re going to wrap things up, but let us know what you want to hear about next Tuesday at 2:00. And we do release this as a podcast on on Thursdays every week, two days after it goes live. So you can listen to it as a podcast as well. Although if you do that, then you can’t ask questions live to us. So. All right. We’ll see you guys next Tuesday, two o’clock Eastern, 11:00 a.m. Pacific. Have a great week, you guys, and reach out. Don’t be a stranger. Let us know what you want to hear about next week. And we will see you on the flip side.