When Does Depreciation Not Help a Property Owner?
Depreciation isn't always a straightforward tax benefit for property owners. Explore how its advantages can be delayed, reduced, or offset by future liabilities.
Property depreciation is a tax deduction that allows real estate investors to recover a property’s cost over its useful life, reducing their annual taxable income. While this is a financial advantage, the benefits are not always guaranteed. Several specific situations can prevent a property owner from realizing these tax savings, turning an expected benefit into a complication.
Properties Ineligible for Depreciation
Not all real estate qualifies for the annual depreciation deduction. The requirement is that the property must be used in a trade or business or held to produce income. This rule excludes certain types of property from eligibility, as the nature of the asset itself determines if its cost can be recovered through depreciation.
Land is a common example of non-depreciable real estate because it has an indefinite useful life and does not wear out like a building. When purchasing a property, an investor must allocate the price between the land and the building. Only the cost basis of the building can be depreciated, and this allocation is often based on a formal appraisal or property tax assessments.
A property owner’s personal residence, including a primary or vacation home used for personal enjoyment, is also ineligible for depreciation. These properties do not meet the requirement of being used to generate income. However, if a portion of a home is used exclusively for business, such as a home office, that specific part may be depreciable.
Suspended Deductions from Passive Activity Loss Rules
The Passive Activity Loss (PAL) rules can delay the tax benefit of depreciation. For tax purposes, rental real estate is generally considered a passive activity, meaning the owner does not materially participate in its day-to-day operations on a regular and substantial basis. When total deductions, including depreciation, exceed rental income, it creates a passive activity loss. These rules limit an investor’s ability to deduct such losses against non-passive income, like wages or portfolio income.
This limitation does not mean the depreciation deduction is lost forever; instead, the loss is suspended and carried forward to future tax years. These suspended losses can be used to offset income from any passive activity in a subsequent year. If an investor continues to have suspended losses, they can be deducted in full in the year the property is sold.
An exception exists for some investors who actively participate in their rental activities. If their modified adjusted gross income (MAGI) is $100,000 or less, they may deduct up to $25,000 in passive losses against non-passive income. This allowance is gradually phased out as MAGI increases from $100,000 to $150,000, at which point it is eliminated.
The Effect of Depreciation on Future Tax Liability
While depreciation provides an annual tax deduction, it also creates a future tax liability realized upon the property’s sale. Each year, depreciation deductions reduce the property’s adjusted cost basis, which is the owner’s investment for tax purposes. A lower basis results in a larger taxable gain when the property is sold.
For example, if an investor buys a property for $400,000 and claims $80,000 in depreciation, the adjusted cost basis becomes $320,000. If the property later sells for $500,000, the taxable gain is $180,000 ($500,000 sale price minus the $320,000 adjusted basis).
A portion of this gain is subject to depreciation recapture. The part of the gain from depreciation deductions is taxed at a maximum rate of 25% as unrecaptured Section 1250 gain. Any remaining gain is taxed at the long-term capital gains rates of 0%, 15%, or 20%, depending on the taxpayer’s income.
The IRS uses an “allowed or allowable” standard for depreciation. This requires an owner to reduce the property’s basis by the amount of depreciation that was allowable, even if the owner failed to claim the deduction on their tax returns. This means an investor who neglects to take annual depreciation deductions receives no tax benefit during ownership but will still face the higher tax bill from depreciation recapture upon selling. The basis is reduced as if the deductions had been taken, resulting in a tax liability on a benefit that was never received.
Interaction with the Alternative Minimum Tax
The Alternative Minimum Tax (AMT) can reduce the benefits of depreciation for certain taxpayers. The AMT is a separate tax system designed to ensure that individuals with high incomes and numerous deductions pay a minimum amount of tax. When calculating income for AMT, some deductions allowed under the regular tax system are modified.
The depreciation calculation for AMT differs from the regular tax calculation, as some properties must use a slower schedule under the Alternative Depreciation System (ADS). The ADS recovery period for residential rental property is 30 years, compared to the standard 27.5 years. For nonresidential property, the ADS period is 40 years.
The difference between the larger regular tax depreciation and the smaller AMT depreciation creates a positive adjustment that is added back to the taxpayer’s income for the AMT calculation. This adjustment increases the alternative minimum taxable income. If the calculated AMT is higher than the regular tax liability, the taxpayer must pay the higher amount, which reduces the benefit of the accelerated depreciation.