Depreciation: The Premier Tax Break for Professionals

Entrepreneurs, doctors, lawyers, business owners and other professional often find themselves in the 32% or 37% tax bracket, face taxes as their greatest expense. As an entrepreneur and business owner, I encountered this firsthand when I needed to purchase a building, office equipment, and production materials. My CPA, Drew, introduced me to strategic tax planning, emphasizing the power of annual depreciation expenses to mitigate tax exposure.

This pivotal discussion reshaped my approach to managing, acquiring, and divesting businesses. Concepts like appreciation, depreciation, deductions, credits, and deferrals took on new significance. Understanding the economic lifespan of assets fundamentally altered my perspective on earnings and the origins of business profitability, significantly influencing the velocity of my wealth accumulation.

Early in my career, I underestimated the impact of taxes on my business operations. Learning about and leveraging tax deductions to reduce taxable income and associated tax liability was a game-changer. Over the past 40 years, I’ve refined my understanding of tax depreciation and the benefits of meticulous tax planning for both business and personal financial health.

At Private Syndication Club, we focus on providing disproportionately productive investment opportunities and financial education. Our goal is to equip Private Syndication Club members with access to the knowledge that will help them to retain more of their earnings. This article aims to plant the seed of financial wisdom, beginning with an understanding of tax depreciation and its importance. We will cover:

• Tax Depreciation and why it is important?
• Capital Gains Tax Why it’s important
• How to perform a depreciation calculation
• How to find out the depreciation rate of property

What Is Depreciation?

Depreciation is one of the most powerful and beneficial wealth-building tools the IRS allows taxpayers.

Tax evasion is a crime, tax mitigation is a moral obligation.  The line of distinction is a critical balance that every business person must develop an acute understanding of. Learning to use tax depreciation to mitigate one’s potential tax liability will likely be the only break you ever get from the US IRS; the world’s largest terrorist organization. Depreciation is a functional tax break available to taxpayers and business owners who have made investments in qualifying asset classes, which allows you to write off the value of the asset over time against your tax liability.

Let’s use an asset class like capital equipment.  It has an intrinsic value usually attached to the manufacturer’s MSRP; In this case, we will use a copying machine.

Once you purchase and install the copier in your office, it immediately begins to depreciate in actual and perceived value.  This simple reality is the foundation of depreciation, It is a real cost of doing business, that the IRS recognizes and allows you to reflect in your taxes over a scheduled period; usually 1,4 or 7 years, depending upon the asset class.  Now while the copier is in good working order and is still in use in your office, it has a known life span, and its value is understood to be diminishing with each print, think of accumulating mileage on a used car. So the IRS allows us to calculate the rate that we attach mileage or depreciation to our copier and deduct from our annual earnings, thus reducing our taxable liability.  It’s that simple

Let’s talk real-world application of the depreciation as a tax mitigation tool concept.  There are different types of depreciation calculations.

Straight-line method

Although both commercial and residential rentalAlthough real estate typically appreciates over time, the IRS permits depreciation over a pre-determined period, creating a paper or phantom loss. For example, residential rental real estate can be depreciated over 27.5 years using the straight-line method.

An example is that they allow owners of resident-occupied real estate an annual depreciation over 27.5 years. This is called the straight-line depreciation method.

An example would be an apartment complex that we purchase. Its cost is $7 million it produces a net income (NOI) of $400,000.

In this sample case,  the underlying land is not depreciable, its assessed value is set at $ 1.5 million.

That leaves the remaining $5.5 million available to be depreciated as follows:

$5.5 million/ 27.5 years = $200,000

Results

As presented in this sample case (we’re assuming you’re in a 37% tax bracket), the IRS allows the accumulated depreciation of $200,000 a year over the next 27.5 years as a paper loss. ($5.5 Million/27.5 yrs = $200,000)

Note*, The case NOI was $400,000 but because of the deduction rule we are NOT going to have to pay taxes on that amount.

Why?

We’re allowed to subtract out the depreciation deductions.

($400,000 – $200,000 = $200,000)

This means that you’re only going to be taxed on the $200,000 of the gross realized total of $400,000.

Tax without depreciation

• $400K x 37% = $148,000

Tax with depreciation

• $200K x 37% = $74,000

As you can see with depreciation, the amount of taxes you pay is cut in half!

The depreciation represents a paper loss that can be taken against the actual gain from the cash flow of the property which gets reported on a K-1.

If you have K-1 passive gains from other business use or activity activity then you can use those to offset actual gains which saves taxes in other areas of your portfolio.

Accelerated depreciation method

Why wait 27.5 years with the straight-line method to benefit when the IRS allows you to front-load or accelerate the depreciation?

This can be accomplished via a cost segregation study which allows items to be depreciated over a shorter period of 5, 7, and 15 years.

This accelerated method creates larger paper losses in the earlier years of an individual’s personal use of the physical capital asset.

Instead of taking the property and dividing it into 2 components (building and land), you now divide it into 4 components:

1. Land
2. Building
3. Personal Property
4. Land Improvements

Personal property is the non-permanently affixed items to the building such as:

• carpet
• cabinets
• drapes

It gets depreciated either over 5 or 7 years.

Land improvements are any improvements to the land such as:

• parking lots
• curbs
• swimming pool
• sidewalks

It gets depreciated over 15 years.

Let’s continue using the example above:

• $7 million purchase price of property
• $1,500,000 land

We’re now left with the $5.5 Million apartment building which we can break up (segregate) into:

• personal property ($600,000)
• land improvements ($500,000)

$5.5 Million – $600,000 – $500,000 = $4,400,000 which is what the building is NOW worth

• $4,400,000 building/27.5 = $160,000

Remember, we’re allowed to depreciate $160,000/year for the next 27.5 years.

• $600,000 personal property/5 = $120,000

We can depreciate $120,000 each year over the next 5 years due to the personal property.

• $500,000 land improvement/15 = $33,200

We can depreciate $33,2000/yr over the next 15 years due to the land improvement.

Total depreciation: $313,340 = ($160,000 + $120,000 + $33,200)

• $400,000 – $313,340 = $86,660

We’re now only taxed on the accelerated depreciation adjusted amount of $86,660

Results

Tax without depreciation

• $400K x 37% = $148,000

Tax with depreciation

• $200K x 37% = $74,000

Tax with accelerated depreciation

• $86,660 x 37% = $32,064

By deploying the accelerated depreciation schedule, our experienced tax liability is reduced further to $32,064.

I hope you’re starting to see how great adding real estate, even passive real estate through a Private Syndication Club Real estate syndication can positively impact upon your investment portfolio; and how it can grow your wealth once you understand the impact of taxation.

Bonus depreciation

Bonus depreciation is a form of accelerated depreciation that allows you to take the benefit of the asset cost in the FIRST year instead of over the 5,7 or 15-year schedule.

In 2017 The Tax Cuts and Jobs Act was passed, under the act, properties purchased post September 27, 2017, and before January 1, 2023, would be able to be depreciated at a rate of 100% in the first year of ownership. This was part of a federal policy initiative centered on stimulating the economy.  It will begin to be phased out at a rate of 20% each year through 2026. So if this type of investment opportunity excites you, you need to act to take advantage of it. 

“OPPORTUNITY WAITS FOR NO ONE”

Let’s revisit our example:

• $7 million property
• $1,500,000 land
• $5,500,000 building / 27.5 = $160,000
• $600,000 personal property / 5 = $600,000
• $500,000 land improvement / 15 = $500,000

Instead of taking the personal property and dividing it by 5 and taking the land improvement and dividing it by 15, we can take the entire benefit in year one.

$160,000 + $600,000 + $500,000 = $1,260,000 in paper loss which cancels out the $400,000 in gains.

The realized benefit is that it leaves you with $860,000 of depreciation in that first year.

Total depreciation: $1,260,000

$400,000 – $1,260,000 = -$860,000

Results

By exercising the bonus depreciation benefit, we’ve wiped out the $400,000 tax liability so we’re taxed on $0 resulting in a liability of zero!

Tax without depreciation

• $400K x 37% = $148,000

Tax with depreciation

• $200K x 37% = $74,000

Tax with accelerated depreciation

• $86,660 x 37% = $32,064

Tax with Bonus Depreciation

• $0 x 37% = $0

At this point, we should be seeing the benefit and importance of understanding taxes and their impact upon our financial lives.

I’m often asked why Depreciation is so critical

Depreciation is critical as it is the most accessible methodology to lower your taxes, bar none legally!

Millions of Americans receive a significant amount of passive income which is reported on their annual IRS K-1, I have always been perplexed by the number of these taxpayers who haven’t invested in understanding the tax lesson you’ve just learned.

Many of these taxpayers would have been able to take advantage of the massive capital benefits of depreciation simply by utilizing a bonus depreciation had they been educated as you just have been.

Let’s say that you are a http://Privatesyndication.club recreational estate investor and you report $200,000 of K-1 passive activity capital gain from your Private Syndication Club investment business and $140,000 of first-year bonus depreciation from a rental property.

Instead of paying tax on $200,000, you are now able to subtract the $140,000 of depreciation and only be taxed on $60,000 of income in that fiscal year.  Would you take me out for a steak and lobster dinner?

Here is where the rubber meets the road.

We have discussed many salient points about taxes and capital gains income retention. We trust this introduction to the extensive knowledge base resident within Private Syndication Club has successfully piqued your interest in becoming an investing member of our investor community.  We also hope you have come to realize how powerful adding syndicated real estate investment into your portfolio can and is likely to be a high-income risk mitigating path toward greater earning for your’ portfolio.