Tax Advantages
Depreciation is the cornerstone of the tax benefits provided by owning real estate. Depreciation is the reduction in the value of an item over time. The IRS has determined that resident occupied real estate has a useful life of 27.5 years.
Lets look at the amazing power of depreciation
Lets say that we're buying a 10 million dollar building and we have 10 investors that each contribute an equal amount of $ 1 million.
The value of the purchase is split into land and building values. We normally attribute 20% to the land, and 80% to the actual building. In our example, that would mean that the building has a value of $8 million and the land value is $2 million.
That $8 million building value is then depreciated over 27.5 years. Using whats called straight line depreciation, that means that there is a paper loss of $209,909 every year for the next 27.5 years.
If we split the paper loss (depreciation) equally amongst our 10 investors, that means that each investor would get a paper loss of $29,090 against any actual gains incurred from distributions.
Depreciation is a powerful tax deferral strategy and is why most investors don't pay taxes on their quarterly distributions for serveral years.
ACCELERATED DEPRECIATION
Accelerated depreciation requires a cost segregation study to identify and value all of the non-structural elements and land improvements. Instead of being depreciated over 27.5 years, those items can be depreciated over much shorter time schedules of 5, 7 and 15 years. This creates even larger paper losses the first few years of owning a property.
By creating paper losses from depreciation, we can offset distributions from the property for many years. Its also possible to use any excess paper losses against other sources of passive activity gain. If you still have excess depreciation, don't worry, you don't lose that benefit, it can be carried forward against future income.