Understanding the Real Estate Depreciation Tax Law

Everyone knows the new tax law went into effect this year. Officially called the Tax Cut and Jobs Act (TCJA) of 2017, the law made sweeping changes to individual and corporate taxation, which have impacted real estate.

The law likely has negative consequences for residential real estate buyers, particularly in New York. It limits state and local tax deductions to $10,000, and you can only deduct mortgage interest on loans up to $750,000, down from $1 million.

However, those that pursue real estate investing as a business likely benefitted from the new tax legislation. Using the ability to deduct more depreciation and hence improve your cash flow. It is an arcane but important consideration.

What is The Depreciation Tax Law?

You can expense certain items, such as mortgage payments, insurance, taxes, and repairs, immediately.

Depreciation falls into a different category. The Internal Revenue Service amount allows you to expense annually for some time for normal wear and tear. Including the purchase price (but not the portion for land) and any long-term improvements you have made. This differs from regular maintenance and repairs, such as a paint job.

In New York, you may choose to invest in condo units, given their preponderance. It is more challenging to purchase co-ops as an investment since the board places restrictions on subletting.

What is Section 179?

This has received a lot of attention. Under the IRS Code, Section 179, you can deduct the entire upfront cost for improvements, subject to a limit. However, according to the IRS, this applies to “qualified real property,” which it defines as a “qualified improvement property” (non-residential building) and some improvements.

The law made it easier for real estate buyers to take advantage of this provision. However, the provision is only available to those that operate real estate as a business. Among other things, you have to pursue a profit and work regularly and continuously (although you can hire someone to manage it for you). If it is an investment, it will not qualify.

If real estate investing is your business, you can now use Section 179 to deduct personal property used in the residential rental. Previously, you could not do so. Therefore, if you buy a new refrigerator or furniture and put it into the rental unit, you can deduct the full amount in the first year. You may also deduct property and equipment that are offsite but used in running the business. These include computers, cell phones, and office equipment.

The upshot is that the new law’s more generous depreciation rules made it more favorable for New York City’s real estate investors who recently purchased property or planned to go forward.

First, the TCJA doubled the maximum allowable deduction to $1 million if you purchased the property in 2018. This increases annually since it adjusts for inflation. Second, there is a phase-out, which the new law increased. The deduction limit currently starts at $2.5 million, which is also inflation-adjusted each year, from $2 million.

Limits

You can only take the deduction to the extent your business earns a profit. Therefore, it cannot create a loss or widen your loss.

The primary advantage of taking a Section 179 deduction is the upfront expense in the first year. However, when you sell the property, the IRS treats this amount as depreciation recapture. This gets taxed at a higher rate (up to 37% plus 3.8% net investment tax) than the capital gains tax rate. If you deduct depreciation over the average 27.5 year recovery period, the tax on that portion of the gain is 25% plus 3.8%.

How Rental Property Depreciation Works

Unlike various investment options such as stocks and bonds, rental property is a depreciable asset. According to the IRS, real estate depreciation is an “annual allowance for the wear and tear, deterioration, or obsolescence of the property.” Note that this is only allowed for investment property and used for the rental income-producing activity. If you use any of it for personal uses, you can only deduct depreciation from the portion used for business.

Depreciation allows you to write off the property maintenance costs over time. Similarly, if you have any capital improvements, such as a major kitchen upgrade, these costs are also allocated over a period than in the year; it was completed—expenses such as general repairs and HOA fees. For example, if you merely paint the kitchen, that is expensed immediately.

Delving Deeper into Rental Property Depreciation

The first thing to know is that you cannot depreciate land. Therefore, you need to separate the cost of the land from the building. Second, for residential real estate, the IRS allows a useful life of 27.5 years. The IRS requires you to use the Modified Accelerated Cost Recovery System (MACRS) to depreciate residential real estate (assuming the property was put in service after 1986). Under MACRS, you can choose to depreciate the property under the straight-line method, which expenses the same amount annually, or under the General Depreciation System, which is more complicated.

Condos and Co-ops

Living in New York City, you may choose to purchase condo or co-op units for rental. If you rent condo units, it becomes challenging since you own the airspace and the common elements, such as the land. If you have a property tax bill that separates the assessed value, you can divide the amount based on this allocation. Alternatively, you can use an independent appraisal or an insurer’s agent’s estimate. If there are special assessments charged for long-term improvements, you can depreciate the allotment you paid.

For co-op rentals, you depreciate the stock owned by the corporation rather than the apartment (which you technically do not own).

Crunching the Numbers

Presenting a simple numerical example should provide more clarity. When purchasing a co-op, calculate the depreciable real property is $1.1 million. You may deduct $40,00straight-liner depreciation expense, assuming you utilize the straight-line method—the $1.1 million divided by 27.5 years.

You cannot have a passive loss in a year (there is an exception if you are an active participant subject to an income limit). However, if you have a $50,000 leftover when subtracting your other expenses from your rental income, this leaves $10,000 of taxable income—your tax savings amount to the annual depreciation multiplied by your marginal tax rate. Assuming you are in the 28% income tax bracket, you saved $11,200 in your taxes for the year.

Concluding Thoughts Rental Depreciation

We have seen how utilizing rental property depreciation and a non-cash expense improves your yearly cash flow. However, we noted this merely defers your taxes. When you sell your property, assuming it has been appreciated, you are subject to a capital gains tax. In figuring this amount, the depreciation is “recaptured.” If you have a cumulative depreciation of $400,000; you owe a depreciation recapture tax at a 25% rate, or $100,000 ($400,000 times 25%).

However, capital gains tax rates are currently lower than those for ordinary income. There are ways to defer taxes on capital gains and depreciation recapture taxes, such as a 1031 tax exchange.