Accelerated Depreciation and The Potential Advantages for Investors

Over the past few years, we’ve seen a few borrowers use accelerated depreciation as a strategy to justify purchasing Outer Banks rental properties. While seasoned real estate investors have the option of traditional depreciation, some investors prefer a much more aggressive approach known as accelerated depreciation. This strategy lowers an investor’s tax bill substantially, or, you might even say, drastically.

Depreciation is an accounting tool that reflects the gradual wear and tear of property and buildings over time. The IRS allows residential properties to be depreciated over 27.5 years. However, with accelerated depreciation, investors can use accounting methods such as the Modified Accelerated Cost Recovery System (MACRS) or Cost Segregation studies to identify components of the property that can be depreciated over shorter lifespans, such as 5, 7, or 15 years.

While I am not a CPA, let’s discuss a simple example: A million-dollar structure traditionally depreciated over 27.5 years, allows for a deduction against rental income of $36,363 in the first year ($1,000,000 divided by 27.5=$36,363). However, $1,000,000 divided by five would allow for a deduction in the first year of $200,000. With traditional depreciation, the tax loss would be minimal because there is rental income on the property. However, using the accelerated depreciation approach the tax loss is more than quadrupling. If investors write off $200,000 in the first year, it almost seems questionable that investors can reduce their tax liability by such a significant amount. I have seen large six-figure tax bills reduced to almost nothing using this method of accelerated depreciation.

For the investors who utilize accelerated depreciation, their desire is to buy another home every year or a few years so they can continue to receive this income tax reduction. When analyzing consecutive years of tax returns and seeing this strategy used year after year, it almost looks addictive. Imagine if your income is over $600,000 per year and you are paying close to $200,000 in federal income taxes each year, but utilizing this strategy, you can reduce this tax bill to almost nothing. The mindset of many investors is the $200,000 saved in taxes, they reinvest to purchase more real estate because they are not paying this in taxes in the first few years of owning the property.

However, it’s important for investors to plan carefully. First, for investors to take these deductions, you must qualify as a real estate professional. This is an important designation that can allow real estate investors to use losses from rental activities to offset non-passive income (such as wages or business income). To qualify, the taxpayer must meet two requirements:

1. Spend more than 750 hours per year materially participating in real estate activities.
2. Ensure that more than 50% of total working time is spent on these real estate activities.

In most cases, clients using this tax strategy are married. One of the spouses, while not necessarily a realtor in the traditional profession, obtained a real estate license to be a property manager. If a spouse is not working a 9-5, then it can be fairly easy to ensure more than 50% of their time is participating in real estate activities.

Before considering accelerated depreciation, investors need to be aware of what happens when they sell their investment property. When an investor sells their property, they must recapture this depreciation. In other words, they have reduced their cost basis, and when selling their investment property, their potential capital gains tax will be much higher. This can lock investors into properties they may not want to sell, as most of the proceeds would be subject to significant cost basis adjustments, leading to large capital gains taxes.

Many investors feel that the upfront tax benefits outweigh future tax implications, making accelerated depreciation a popular choice among those willing to meet the two above requirements. Overall, leveraging this strategy allows investors to maximize cash flow, reduce tax burdens, and reinvest in growing their real estate portfolios.

Again, I am not a tax professional, and I am not endorsing the use of accelerated depreciation. After extensive research, I decided it wasn’t for me personally. When talking to different accountants more than one CPA has mentioned that using accelerated depreciation often leads to audits, although clients who have used this strategy reported their audits went well.