A Real Estate Investor’s Guide to Accelerated Depreciation

When you hear stories about real estate investors paying far less in taxes than employees, it’s often due to a tax strategy called depreciation. This legal tool allows investors to lower their taxable income by writing off the gradual wear and tear on their properties over time.

And it’s not just for wealthy investors—anyone who owns investment real estate can use this tax-saving tool.

In this blog, we’ll break down how depreciation works, how accelerated depreciation can further boost tax savings, and why real estate investors should take advantage of this powerful tax incentive.

What Is Depreciation?

Depreciation is a tax incentive the Internal Revenue Service (IRS)  provides to all real estate investors. It allows them to account for the natural aging and use of their properties.

However, not everything on a property can be depreciated. The land itself is not depreciable because it doesn’t wear out, but all the improvements on the land—such as the building structure, windows, drywall, countertops, cabinets, roof, and HVAC system—are eligible.

To understand how depreciation works, let’s break it down with an example:

• Suppose you own a rental property worth $1.5 million.
• The land is worth $500,000, which cannot be depreciated.
• The remaining $1 million represents the improvements on the property, which can be depreciated.

The IRS allows a depreciation rate of 3.5% per year for real estate.

• 5% of $1 million = $35,000
• This means you can deduct $35,000 from your taxable income every year.

For example, if you earned $100,000 in rental income, this depreciation deduction would lower your taxable income to $65,000, reducing your tax bill significantly.

What Is Accelerated Depreciation?

Accelerated depreciation is a method that allows investors to take larger depreciation deductions upfront, rather than spreading them evenly over decades.

For multifamily and commercial real estate investors, this means:

• Lower taxable income sooner
• More cash flow for reinvestment

The most common way to achieve accelerated depreciation is by scaling up depreciation using a Cost Segregation Study.

How Investors Scale Depreciation with Cost Segregation

A Cost Segregation Study is a process that allows investors to break down the property into individual components with different depreciation schedules.

Instead of depreciating everything evenly over 27.5 years, a cost segregation study might allow investors to:

• Depreciate certain assets more quickly, allowing for bigger tax deductions in the early years.
• Increase tax savings in the short term, freeing up more cash flow for reinvestment.

How Much Can an Investor Save?

Depreciation is a powerful tax-saving tool for real estate investors. Here’s how it can work:

• Investors can deduct depreciation on rental properties to reduce taxable income.
• The IRS allows annual depreciation deductions, lowering the amount of taxes owed.
• Savings from depreciation can be reinvested into new properties, fueling portfolio growth.

Let’s say you own a few rental properties and qualify for $27,000 in annual depreciation deductions.

• If your tax rate is 35%, this could result in up to $9,450 in potential tax savings.
• These savings may be reinvested into a new property as a down payment or used for other investments.
• Depreciation helps investors keep more of their earnings working for them instead of paying higher taxes.

By understanding and leveraging depreciation, real estate investors can maximize tax benefits while staying compliant with IRS guidelines.

Key Terms to Help You Navigate Depreciation

Depreciation is a powerful tax-saving tool, but understanding how it works is key to maximizing its benefits. Whether you’re new to real estate investing or looking to refine your tax strategy, these essential terms will help you navigate depreciation with confidence.

Depreciation

A tax deduction that allows real estate investors to offset the natural wear and tear of a property over time. The IRS permits depreciation on buildings and improvements but not on land.

Accelerated Depreciation

A strategy that enables investors to increase their depreciation deductions in the early years of ownership, helping them reduce taxable income faster.

Cost Segregation Study

A detailed breakdown of a property’s components allows investors to accelerate depreciation on certain assets, such as appliances and fixtures. This method is often used for multifamily and commercial real estate.

Tax Write-Off

A reduction in taxable income due to certain expenses or deductions. Depreciation acts as a tax write-off, helping real estate investors lower their overall tax liability.

Taxable Income

The portion of an investor’s earnings that is subject to federal and state income taxes. Depreciation reduces taxable income, meaning investors owe less in taxes.

Tax Liability

The total amount of taxes owed to the IRS. Depreciation and other deductions help lower this amount, allowing investors to keep more of their income.

Cash Flow

The remaining income from an investment property after expenses and taxes. By maximizing depreciation deductions, investors can keep more money in their pocket instead of paying higher taxes.

Federal Income Tax

The tax imposed by the federal government on an individual’s or business’s earnings. Depreciation helps reduce taxable income before federal income tax is calculated.

Investment Property

A property purchased with the intention of generating income, either through rental earnings, appreciation, or tax benefits. Investment properties qualify for depreciation deductions.

Maximizing Your Investment with Depreciation

Depreciation is one of the most valuable tax benefits for real estate investors. By strategically using depreciation, investors can lower their tax liability, improve cash flow, and reinvest their savings into additional investment properties.

If you’re considering real estate investing or want to understand how depreciation fits into your financial strategy, Mike Schlichte and the team at Absolute Real Estate can help.

Whether you’re buying your first investment property or expanding your portfolio, they’re ready to guide you through the process and answer any questions.