What is a depreciation schedule?

A depreciation schedule is a comprehensive accounting record that monitors the gradual decline in value of an asset throughout its useful life. For real estate investors, these schedules serve as valuable tax tools, enabling you to deduct the cost of income-generating properties over time, which can significantly lower your taxable income without impacting your cash flow.

Depreciation Basics

Depreciation refers to the wear and tear, deterioration, or obsolescence of property as time passes. In accounting, it involves the systematic distribution of an asset's cost over its useful life. Although physical assets like buildings do experience deterioration, depreciation for tax purposes mainly functions as a tax-deduction strategy rather than a true representation of changes in property value.

Creating an Effective Depreciation Schedule

Step 1: Determine the Property's Cost Basis

Step 2: Separate Land from Improvements

Step 3: Identify Depreciable Components

Step 4: Calculate Annual Depreciation

Step 5: Create a Depreciation Schedule

Common Mistakes to Avoid

• Failing to separate land from improvements: Land is not subject to depreciation, so not allocating a portion of your purchase price to land can lead to scrutiny from the IRS.

  
  

• Incorrect placed-in-service date: Depreciation starts when the property is ready and available for rent, not when it is actually rented out.

  
  

• Overlooking component-based depreciation: Many investors miss the chance to accelerate depreciation by not identifying shorter-lived components within their property.

  
  

• Depreciating non-rental portions: If you use part of your property for personal reasons, you can only depreciate the portion that is rented out.

  
  

• Continuing depreciation after basis is fully recovered: Once you have depreciated the entire cost basis, you need to stop claiming depreciation deductions.

  
  

• Neglecting to recapture depreciation upon sale: Many investors are surprised by depreciation recapture taxes when selling, as previous depreciation deductions are taxed at up to 25%.

  
  

• Missing mid-month convention adjustments: For residential rental properties, depreciation follows a mid-month convention, which means you receive a half-month of depreciation for the month the property is placed in service.

  
  

• Failing to adjust basis for capital improvements: Significant improvements should be added to the property's basis and depreciated separately.

---

Advanced Depreciation Strategies

Cost Segregation Studies

A cost segregation study involves a thorough engineering analysis that identifies and reclassifies various components of a property to allow for shorter recovery periods. Although these studies can be costly, they have the potential to greatly speed up depreciation deductions.

Bonus Depreciation

For qualified property placed in service after September 27, 2017, bonus depreciation allows for immediate expensing of a percentage of the asset's cost. This applies to many components identified in cost segregation studies.

Section 179 Expensing

Although it typically doesn't apply to residential rental buildings as a whole, Section 179 does permit the immediate expensing of specific qualifying components found within rental properties.

Tax Implications of Depreciation

Depreciation Recapture

If you sell property that has undergone depreciation, you might encounter depreciation recapture taxes. The recaptured depreciation is taxed at a maximum rate of 25%, which is higher than the more favorable capital gains rates.

Passive Activity Limitations

Rental property depreciation is typically classified as a passive activity loss. However, this loss may be restricted if your income surpasses specific thresholds.

Impact on Basis

Depreciation lowers the tax basis of your property, potentially raising your capital gain when you sell it.

---

Conclusion

A well-organized depreciation schedule is crucial for real estate investors, enabling them to take advantage of substantial tax deductions while ensuring a positive cash flow. By familiarizing yourself with different depreciation methods, recovery periods, and common mistakes, you can enhance the tax advantages of your real estate investments while staying compliant with IRS regulations.

Investing the time to develop a precise depreciation schedule can lead to significant tax savings throughout the duration of your investment property. Keep in mind that while depreciation offers important tax benefits during ownership, it's also vital to plan for potential depreciation recapture to ensure long-term investment success.