Depreciation a business owner reduce their tax liability in the years that they own real estate utilized for business purposes.
The depreciation is effectively a temporary adjustment that will be recaptured when the property is sold. The good news is that the recapture rate is typically lower than your federal income tax rate, so you benefit from taking the depreciation on your investment property, even if you have to pay it back in the future.
Reduce your overall tax liability as long as your Federal Tax Rate is higher than your Depreciation Recapture Rate.
When your reduce your tax liability, you save money and that money can be invested to produce a return. You can multiply the expected annual return on any investment you will make with that money to determine the time value of this money.
When your reduce your tax liability, you save money and that money can be used to pay down any debts. In that case, you would multiply the tax savings by the annual interest rate on the debt.
The accelerated depreciation helps you reduce your tax liability when you first purchase a property and that improves the overall cash flow for you or your business. Increased cashflow can make or break your business in a challenging economic environment.
If you purchase a hotel and you claim $1,000,000 in depreciation over 3 years, this will reduce your tax liability in line with the level of your income taxes. If you are at a 35% federal income tax rate and you have no state tax, you would save $350,000 in federal income taxes from the depreciation you elected to claim.
$1,000,000 In Depreciation x Federal Tax Rate of 35% = $350,000 Reduction To Tax Liability
When the property is sold, you would be subject to recapture at a rate of 25%. In order to make a profit, you need to sell the property for more than your cash investment and the amount of the depreciation recapture.
$1,000,000 Depreciation Recaptured As Income x 25% Recapture Rate = $250,000 Tax Liability
The net result of this investors savings is $100,000 which represents the difference between his Federal Tax Rate and the Depreciation Recapture Rate.
MACRS provides three depreciation methods under GDS and one depreciation method under ADS. Fortunately, most properties recently placed in service utilize the ADS method which utilizes the simple straight line depreciation.
Depreciation is the recovery of the cost of your property over a number of years. Typically, you deduct a part of the cost every year until you fully recover its cost. You may elect to treat qualified real property as qualifying property under Section 179. Qualified real property (i) is qualified improvement property (QIP) described in Section 168(e)(6), and (ii) is any of the following improvements that are made to nonresidential real property and placed in service after the date such nonresidential real property was first placed in service: roofs; heating, ventilation and air-conditioning property; fire protection and alarm systems; and security systems.
“You can depreciate the value of improvements to the land and the value of the personal property used for your business. You can not depreciate the value of the land.”
You may be able to elect under Section 179 to recover all or part of the cost of qualifying property, up to a certain determinable dollar limit, in the taxable year you place the qualifying property in service.
For properties placed In service from September 27, 2017 to January 1, 2023, you may be able to take a special depreciation allowance equal to 100% of the qualifying deductions.
For properties placed In service after December 31, 2022, the special depreciation allowance is 80 percent of the qualifying deductions.
“Special Depreciation is applied after any allowable Section 179 deductions and before any other depreciation is allowed.”
The total cost you can deduct after you apply the dollar limit is limited to your taxable income derived from the active conduct of any trade or business during the taxable year.
“If your depreciation amount exceeds your income on the current year's tax return, the portion that is unused will be carried over to the following year.”
Yes, there are also special rules and limits for depreciation of listed property. The Cost Segregation Study within this report includes a breakdown of the depreciable assets to support your claims for deductions. You may be able to depreciate property that meets all the following requirements:
Excepted property includes intangible property, certain term interests, equipment used to build capital improvements, and property placed in service and disposed of in the same year.
To learn more about depreciating property, visit the IRS website.
Generally, if we are depreciating property that was placed in service before 1987, we use the Accelerated Cost Recovery System (ACRS) or the same method you used in the past.
For property placed in service after 1986, we generally must use the Modified Accelerated Cost Recovery System (MACRS).
As an example, if you took a deduction that was worth 37% federal, you would only pay 25% federal taxes when it is recaptured. Not only is there an arbitrage between rates there, but there is a time value of money. You got to use those saved taxes for up to 39 years before paying them. In addition, if you exchange the property (instead of selling it) over and over again between now and the end of your life and your heirs get the step up in basis at death, that depreciation may never be recaptured.
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