When a taxpayer buys an investment property such as a Duplex, the money he pays for it is not an expense that can be deducted from the income produced by the property before the taxable income is determined.
Only the interest paid on the loan, if there is a loan, is deductible, because interest is a deductible business expense.
It seems unfair, and maybe it is, but the way the IRS makes this situation great for real estate investors is through what is called "Depreciation Allowance," which is usually just referred to as Depreciation.
Depreciation is not an actual out-of-pocket expense, but the taxpayer can deduct it like any other business expense because it is what the IRS considers an "Expense Allocation."
The IRS explanation for this system is that during the life of the asset, as the asset is producing income, it will be wearing out. Therefore, the deduction of the amount paid should be taken over the life of the asset, as it wears out, and as it is producing income.
It sounds good, but it is difficult to reconcile with Section 179 Bonus Depreciation, in which the taxpayer can take an immediate 100% Depreciation Deduction in the first year for certain new of used personal assets purchased for the business.
But let's just take it as it is.
The assets that you purchase and depreciate will have a "life," the period of time over which the asset can be depreciated.
It is not the actual life of the asset, but a number assigned by the IRS.
The Depreciation will either be Straight-line Depreciation, or Accelerated Depreciation.
Here is a video to help explain Straight-line Depreciation:
Many investors have made more money by using Depreciation wisely than in negotiating the lowest possible prices on properties.
I strongly recommend that you learn everything you can about Depreciation. There is a lot of room for flexibility here that can have a major effect on your taxes.
Accelerated Appreciation
Depreciation is the annual "expense allocation" that the IRS allows you to deduct from the operating income of your investment real estate, even though it is not a cash, out-of-pocket expense.
There are different categories of property that can be depreciated, such as real property and personal property.
The real property is usually referred to as Section 1250 Property.
The personal property is usually referred to as Section 1245 Property.
Accelerated Depreciation, instead of Straight-Line Depreciation, is available for part of your investment property that is made up of what the IRS classifies as personal property, the Section 1245 Property.
With Straight-Line Depreciation if you had an asset with a 10-year life, you would be allowed to deduct 1/10th (10%) of your purchase price each years a a depreciation allowance.
But with Accelerated Depreciation,, you will be allowed to deduct more than 10% each year.
Double Declining Balance
The most popular type of Accelerated Depreciation is called Double Declining Balance, referred to as DDB.
When a taxpayer buys an investment property such as a Duplex, the money he pays for it is not an expense that can be deducted from the income produced by the property before the taxable income amount is determined.
Most investment real estate is property that the IRS classifies as Section 1250 Property, which usually means it is a building.
But the portion of the real estate investment property called "Personal Property" by the IRS, even thought it is actually business property that is not part of the real estate, is classified as Section 1245 Property.
And Section 1245 Property can be depreciated using Accelerated Depreciation as the method described here.
The Depreciation method called Double Declining Balance, referred to as DDB, allows you to deduct more depreciation in the beginning of the life of the asset than you would be able to with Straight-Line Depreciation (SD).
If you have a $10,000 asset with a 10-year life, SD would allow you to deduct one-tenth, or 10%, of the value as a depreciation allowance the first year, a total of $1,000.
By using the DDB method, you will be able to deduct twice the amount, 20% or a total of $2,000.
Here's how that would work.
After the first year, the book value of the asset has declined to $8,000 because you have taken a $2,000 depreciation allowance.
So, for the second year you can deduct 20% again, but not of the $10,000. You can deduct 20% of $8,000 balance. The balance is declining. This balance is what is being referred to by the title of depreciation method, "Declining Balance."
Your second year deduction is 20% of $8,000 = $1,600.
This causes the book value balance to decline to $6,400.
Your third year deduction is 20% of $6,400 = $1,280.
Your fourth year deduction is 20% of $5120 = $1024.
Depreciation is all about recovering your capital expenses as quickly as possible, and the DDB method is the most popular way of doing that.
Here is a free online calculator for Double Declining Balance
Here is a video to help explain Double Declining Balance:
There are two more types of Accelerated Depreciation.
One is called 150% Declining Balance, referred to as 150DB.
The other type of Accelerated Depreciation is Sum-of-the-Year-Digits, which is almost never used.
An important distinction for you to note about Accelerated Depreciation is that while you are now using it to shield your income from your current tax bracket liability, you will pay a different tax rate when you eventually sell the property and have to pay a Depreciation Recapture tax.
For Straight-line Depreciation Recapture, the tax rate is 25%.
But for Depreciation Recapture of Accelerated Depreciation, the tax rate is whatever you individual tax rate is for that tax year. And for a tax year in which you sell a large investment property, you could be in a much higher tax bracket.
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