When purchasing investment property, most people focus on the benefits of cash flow and passive income. However, there is an even greater benefit that is often overlooked and not completely understood, until you have owned property for a period of time – Depreciation.
Real estate depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property placed into service by the investor. Depreciation is essentially a non-cash deduction that reduces the investor’s taxable income. It assumes that the rental property is actually declining over time as a result of wear and tear. But we know this is not typically the case.
Below are the types of property depreciation:
There are two ways to accelerate the depreciation schedule of an asset. The first option is to elect the modified accelerated cost recovery system on your taxes. This system lets you deduct a higher percentage of an asset's cost during its early years of use. The other option is to elect the Section 179 deduction for your purchases. The Section 179 deduction lets you deduct up to $500,000 of asset purchases immediately, you do not need to spread the deduction over the assets' lives.
Higher Upfront Deduction
The main advantage of an accelerated depreciation system is it lets you take a higher deduction immediately. By receiving a higher depreciation deduction today, a business will reduce its current tax bill. This deduction is especially helpful for new businesses that may be having short-term cash-flow problems. The money saved on taxes can be reinvested in the business to continue its growth. Accelerated depreciation lets businesses maximize deductions today and avoid delaying deductions to the future when the business may no longer exist.
Lower Future Deduction
An accelerated depreciation system only speeds up the recognition of depreciation deductions. These systems do not create a larger tax deduction. The higher upfront depreciation deduction from these systems comes at the expense of a lower deduction in the future. For a growing business, this can be a problem. As a business grows its income, it will move into a higher tax rate. By accelerating your business's deductions, you will have fewer options in the future to reduce your taxes when you business may be in a higher tax bracket.
Another problem with accelerated depreciation systems is they have a greater risk of recaptured depreciation. You may decide to sell a long-term asset before it is considered worthless according to its depreciation schedule. If you sell the asset for more than its current accounting value, your profit will be considered recaptured depreciation. The IRS will take back your depreciation deductions as the asset did not lose value as quickly as predicted. Your recaptured depreciation profits will be taxed as income. Accelerated systems have a higher cost of recaptured depreciation because they recognize more depreciation upfront.