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Depreciation Schedule for a Multifamily Property: Everything Investors Should Know

Author: Tomás Fonseca

A depreciation schedule is a fantastic tool for real estate investors. It reports the actual value of your fixed asset, allowing you to utilize the maximum annual tax deduction available. 

If you own a multifamily property or you’re preparing to buy one, this is one of the most amazing and useful tools you can use.

This article will take you through everything you should know about depreciation schedules for multifamily properties. More extensively, we’ll consider rental property depreciation of multifamily properties, cost segregation and its benefits, among other things. However, before we get into all that, let’s first consider the concept of depreciation.

Depreciation and Taxable Income

Many physical assets don’t appreciate in value over time. Rather, with the passage of time, many of their parts gradually deteriorate or become outdated. 

There’s a crucial need to keep these deteriorating parts in perfect condition through repairs and upgrades, hence the essence of the depreciation concept.

Real estate depreciation is a process that allows a taxpayer to recover the cost of a real estate investment (buying and improving their personal property) through an income tax deduction. Annually, the United States tax laws allow investors to take a deduction from their income tax for depreciation. 

This means that if you have a rental property generating $15,000 annually, correctly applied depreciation rules could potentially reduce your taxable income to less than $10,000. This is what many real estate investors are enjoying on their rental properties when they file their annual tax returns. 

Conventionally, multifamily properties across the United States have a depreciation period of 27.5 years at a 3.636 percent rate. That is, the property’s value is divided by 27.5 years. Commercial real estate on the other hand has a 39-year depreciation period.

It's crucial to note that with a depreciation deduction, only the value of the building is considered, not the land. Unlike the building, the land value never depreciates. It's therefore considered to have an indefinite useful life. 

Nevertheless, not all money spent can be considered for a tax deduction. According to the IRS, insurance, property taxes, medical expenses, and rental property expenses can all be written off for tax purposes.

Man using calculator beside toy house

Multifamily Property and Depreciation Deductions

Like other physical assets, a multifamily property also depreciates in value over the years. However, the property continues to generate value for the investor through the rental income. 

Depreciation is even more beneficial for a multifamily property because while the building’s value continues to depreciate, the investor continues to earn the rental income it generates. 

For multifamily properties, the IRS oversees the amount of depreciation that can be taken every year. The depreciated amount is indicated as a line item on the profit and loss statement of the property and it reduces taxable income.

Furthermore, according to tax law, a multifamily property can be depreciated over 27.5 years. Once you’ve determined the useful life of your asset, there’s a formula for calculating the value lost to depreciation every year and claiming depreciation deductions.

Calculating Depreciation for Multifamily Property

For a multifamily property, calculating depreciation is quite simple if you’ve held the property for at least one year. However, it has some key conditions.

Cost Basis: The original purchase price of an asset is called the cost basis. 

Useful Life: The useful life refers to the estimated amount of time an asset is expected to be fit for use.

To calculate depreciation on your personal property, divide the cost basis by 27.5, which is its useful life. 

Multifamily Property Depreciation Amount = Cost Basis / Useful life

This method is also referred to as the straight-line depreciation method. But, how does this work in practical terms? Here’s a simplified example:

Mr. A owns a multifamily apartment valued at $700,000 with a useful life of 27.5 years. To calculate its depreciation expense, simply divide $700,000 by 27.5. The annual depreciation expense is $25, 926.

However, if this personal property has only been in service for a few months, you can only pro-rata a lesser depreciation amount for that year. For example, if you bought a new property in April and began renting it out in September, you can only depreciate a certain percentage. 

The IRS provides the following Residential Rental Property GDS table for this purpose.

January

3.485%

February

3.182%

March

2.879%

April

2.576%

May

2.273%

June

1.970%

July

1.667%

August

1.364%

September

1.061%

October

0.758%

November

0.455%

December

0.152%

Source: IRS

If you own a $250,000 rental property purchased in April and put it to service in September like the above example, you can only depreciate 1.061 percent in the first year according to the above table. This implies that your depreciation deduction for the first year will be $2,356.27.

Nevertheless, according to IRS guidelines, not all multifamily properties can be depreciated. A multifamily property can only be depreciated if it meets ALL the following requirements:

  • It's your personal property. You own it, even if there’s a mortgage on it. A tenant subletting his apartment to another can't claim depreciation.

  • The property must be used for income-generating activity. That is, it must be a rental property.

  • The property —the building and its accompanying appliances— are expected to last more than one year. 

  • The property should have a determinable useful life.

On top of document are ballpen and calculator

Depreciation Schedule

If you have real estate investment, depreciation offers the potential for huge tax deductions. However, drawing up a schedule can help you take full advantage of it. 

A depreciation schedule is a report that forecasts the true value of your fixed assets. It’s the perfect aid for any investor because it offers all kinds of useful information that helps to monitor their long-term assets. 

This helps them understand the true value of their asset while claiming the maximum depreciation deduction available.

Why You Need One

A depreciation schedule doesn’t only offer tax benefits, it also offers other advantages. Year after year, many real estate investors miss out on opportunities because they didn't discover some of the following benefits:

  • It helps you understand the true state of your property

  • It saves you money and boosts your business’ cash flow

  • It can save you the time and stress of calculating the deductions yourself

What Should Your Schedule Include?

To break it down, the schedule should include:

  1. A description of the property

  2. Date of purchase

  3. The total cost of the asset

  4. Expected useful life

  5. Depreciation method used

  6. Salvage detraction

  7. Current year depreciation

  8. Accumulated depreciation

  9. Netbook value = Cost of an asset – Accumulated Depreciation

With depreciation, real estate investors can reduce their tax liability. However, there are even more ways to significantly reduce tax liability and increase deductions. This is where cost segregation comes into play.

Cost Segregation

What is Cost Segregation and How Does it Work?

Like depreciation, cost segregation is a tax benefit but it allows rental property owners to enjoy even more deductions. While depreciation only involves the value of the building, cost segregation includes the value of depreciation of any tangible personal property. 

With cost segregation, rental property owners can reduce their tax liability by providing a massive boost to the rate of deductions over income taxes. 

Cost segregation studies are usually carried out by engineers because it involves a physical inspection of the building’s structure. The report usually categorizes the property into the following categories: 

  • Personal property

  • Land improvements

  • Building components 

  • Land

Nevertheless, property categorization isn't as straightforward as it may seem. There isn't an easy way to clearly categorize tangible personal property and a building's structural components.

Man writing on paper beside with calculator

Calculating Depreciation With Cost Segregation

Suppose you own a multifamily property that comes fitted with other appliances. It is valued at $1,000,000 and the appliances are worth $250,000. Calculating the depreciation expense involves the following steps:

  1. Asset’s value = $1,000,000 - $250,000 = $750,000

  2. Depreciation expense for property alone = $750,000/27.5 = $27,272.73

  3. Depreciation expense plus Cost Segregation = $250,000/7 = $35.71

  4. Total depreciation: $27,272.73 + $35.71

From the above example, it’s obvious that with cost segregation, the depreciation expense offers even more tax savings on the property.

When Can You Conduct a Cost Segregation Study?

Cost segregation studies remain some of the most effective methods for getting bigger tax cuts and property owners are learning to take advantage of it. But, is there a required timeline to conduct the study? 

Ideally, you can conduct a cost segregation study anytime after you've purchased or constructed the property. However, the study should be carried out by an experienced professional. 

While anyone can carry out a basic study, it takes knowledge, experience and professionalism to produce a quality cost segregation study.

Cost Segregation Benefits

Cost segregation is one of the most beneficial tax strategies which any real estate investor can employ. Here are some of its most noteworthy benefits.

  • Reduced Tax Burdens

As a real estate investor, cost segregation is one of the best ways to reduce your tax burdens. During the early days of your assets, accelerated depreciation deductions lessen your taxable income and instantly increase cash flow. 

With your tax burdens reduced, you have more cash at hand to “play around”. Depending on you, increased cash flow could imply various things such as increased opportunities for long-term or short-term investments. You could simply inject more funds into your current business too.

  • Accelerated Depreciation Schedules

Also, cost segregation allows you to optimize the amount of depreciation you can claim. As an investor, you can reduce the book value of your asset at a heightened rate early in its useful life. Put simply, you can deduct the costs of your assets quicker than their value declines.

  • It Creates a Proper Audit Trail for Your Business

Another crucial cost segregation benefit is that it structures an audit trail of costs and assets. This is an important benefit for businesses as improper documentation is one of the top reasons many businesses fail. A proper audit trail also helps you to quickly resolve IRS reviews.

  • Takes Advantage of Retroactive Benefits

Due to the 1996 rule change, taxpayers can now perform a retroactive cost segregation analysis and capture savings on properties added since 1987. 

In the past, previous rules only permitted a catch-up period of four years, placing a limit on retroactive savings. This is no longer the case and taxpayers can now take the entire adjustment amount upon completion of cost segregation in the same year.

  • Time Value of Money (TVM) and Other Benefits 

Investors in the rental property business find cost segregation incredibly beneficial due to its TVM benefits. The TVM is a concept that an amount of money in the present holds more value than the same amount in the future.  

Cost segregation studies may also help you identify additional benefits such as opportunities for tax savings.

Conclusion

Conclusively, multifamily property depreciation is one of the most effective ways to lighten your tax burdens. It can be a valuable tool that can save you a lot of money in the form of tax deductions. 

Many real estate investors have been enjoying drastic tax savings. If you’re a property owner and this is your first time reading about depreciation, it may seem slightly complicated. However, it’s worth taking your time to figure it out to truly learn what you need.

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Tomás Fonseca

About the author

Host of the Multifamily Masters Summit Podcast and eXp Realty Mini-Series Podcast.

Podcast whisperer and a smile producer, Tomás Fonseca takes his Portuguese sway into all of his interactions. I guess that's what it makes him likeable...or so he thinks. Tomás probably travels more than works, but we are fine with it.