Depreciation: Residential vs. All Other
Depreciation is another thick concept, and it is important to understand how it may affect your after tax portfolio returns.
Depreciation, as an income tax deduction, represents the cost of replacing items that wear out. For real estate, the improvements can be depreciated. Looking at any property, a certain amount of its value is in the land, which we cannot depreciate, because land is not something that will need to be replaced (except for properties having mineral rights). The balance is the buildings and improvements that represent a potential income tax deduction. The IRS presumes that residential property improvements(including multifamily apartment and student housing) will last 27.5 years, and other commercial property improvements will last 39 years. Using a Hypothetical example of a $5,000,000 residential property, of which $1,000,000 represents land, the remaining $4,000,000 is considered “improvements to the land”, and may be divided by 27.5 years, giving the owner a potential tax deduction of $145,455 every year for 27.5 years. If the property was office or retail, for example, the depreciation would last 39 years and would potentially be $102,564 a year. Depreciation is used on your tax return, Schedule E, as an expense, and is itemized in just the same way as mortgage interest paid, insurance or repairs. It’s a straight deduction from your income from the property.
This is another important consideration when selecting the type of property in which you will invest. We advise our clients to focus on potential after-tax cash flow in their evaluation of which properties to buy, and not on potential gross cash flow. A hypothetical retail property may have a projected 6.5% gross cash flow, and a hypothetical multifamily apartment just 6.00%, however, we often find that multifamily apartment offerings can provide a higher after tax cash flow than retail properties as a result of their shorter depreciation schedule. See the hypothetical illustration below as a general guide to understand the concept of depreciation.
|1. Net Income is Total Income – Total Expense
2. This may be considered roughly hypothetically equivalent to projected first year cash flow shown in the offering documents Calculated (Total Income – Total Expense) / (Equity Percent X Value)
3. For Residential Property, Annual Depreciation is (Property Improvement Percentage) / 27.5 Years For Other Property, Depreciation is (Property Value X Improvement Percentage) / 39 Years
4. Taxable Income is Income Before Depreciation – Expense
5. Tax Due is Tax Rate X Taxable Income
6. After Tax Income is Income Before Depreciation – Tax Due
7. Cash on Cash After Taxes is After Tax Income
In the hypothetical illustration above, the multifamily apartment property shows a projected 5.94% cash on cash after tax, and the hypothetical retail property shows only a 5.66% cash on cash after tax. You can see how important depreciation becomes. All other things being equal, the more you can potentially depreciate each year, the lower your tax bill. A lower tax bill translates directly into dollars into your pocket. Working to maximize depreciation is an important tax component of DSTs. A more robust depreciation tax shelter is one reason that we often favor multifamily apartment and student housing offerings over commercial office or retail properties. However, depreciation is just one factor to consider, and there could be other overriding aspects. One wouldn’t make an investment decision simply based on depreciation allowance alone. The table is a theoretical example presented in order to illustrate how depreciation can impact after tax returns. Any use of hypothetical cash on cash or total returns are presented for conceptual purposes only and should not be construed to be any actual projections of income and/or projected rates of return associated with an investment in DSTs.
This is neither an offer to sell nor a solicitation of an offer to buy any security which can only be made by prospectus. Investing in real estate and 1031 exchange replacement properties may not be suitable for all investors and may involve significant risks. These risks include, but are not limited to, lack of liquidity, loss of principal, limited transferability, conflicts of interest and real estate fluctuations based upon a number of factors, which may include changes in interest rates, laws, operating expenses, insurance costs and tenant turnover. Investors should also understand all fees associated with a particular investment and how those fees could affect the overall performance of the investment. Employees of Archer Investment Advisors and LightPath Capital, Inc. do not provide tax or legal advice, as such advice can only be provided by a qualified tax or legal professional, who all investors should consult prior to making any investment decision. Archer Investment Advisors is a branch office of LightPath Capital, Inc. Securities offered through LightPath Capital, Inc. Member FINRA/SIPC.