90% of Real Estate Investors Don’t Know This
The 6 Hidden Rules of Depreciation
Every week I pick a different topic to brush up on.
I draft a mile long prompt, punch it into Claude, and let AI be my professor.
Most recently I dove into depreciation.
Like most investors, I knew the basics.
Tax benefits.
Useful life of properties.
Exclusion of land from cost basis.
But that was about it.
My understanding pretty much stopped there.
I always told myself: “I’m a real estate investor, not a CPA. A lot of this stuff should be left to the accountants.”
And I’ll be honest, I still feel this way.
I firmly believe that real estate is a team sport and every player has a designated role to play.
As the point guard, my job is to: read the court, spot weakness in the defense, and put my teammates in a position to score.
I shouldn’t be down in the paint competing with power forwards and centers to grab rebounds.
This same philosophy applies to investing.
As a principal and operator, my primary objective is to: maintain a thorough understanding of the overall state of the market, identify hidden value, and leverage others to minimize risk while maximizing returns.
It’s impractical to think that I can do this well, while also doing the job of my attorney, lender, insurance broker, and tax advisor.
But. . . there’s a caveat to this framework.
The more general knowledge you acquire, the deeper your domain specific understanding grows.
In other words, when you have a strong grasp of every player’s position, you can play your part at the highest level.
An inch wide and a mile deep simply isn’t enough.
So I went 2 inches wide and 10 miles deep.
These are the six new rules and principles I gathered along the way.
I’m pretty confident that some (or all) of what I’m about to share, will come as new knowledge.
(It was to me).
Rule #1: Allowable Depreciation Assumption
The IRS assumes that you take full advantage of all “allowable depreciation”—regardless of whether you use it or not.
Per IRC §1016(a)(2), if depreciation was available but you failed to take it, the IRS still reduces your basis and taxes the recapture anyway.
For example:
You bring in $40,000 in taxable rental income for 2024.
And $50,000 in taxable rental income for 2025.
For both years your allowable depreciation (i.e. the amount of depreciation you’re able to claim in any given year that the property is placed in service) was $23,636.
Even if you chose not to claim the $23,636 for each year (i.e. reduce your taxable rental income proportional to your annual allowable depreciation), the IRS will assume you did.
As a result, if you were to sell the property, you would incur a depreciation recapture tax on the $47,272 that was available to claim during those two years that the property was in service.
Closing Note: Depreciation recapture applies to the lesser of: 1. Total depreciation (allowed or allowable), or 2. Total gain on sale
Rule #2: The Placed In Service Principle
Most investors know that there are two main categories of recovery periods when it comes to depreciation - 27.5 years for residential real estate and 39 years for non-residential commercial real estate.
But when does this recovery period start?
Is it: when you purchase the property? when you’re done renovating? or when the tenant’s lease starts?
It’s none of the above.
The depreciation clock starts ticking when the property is “placed in service”. And the IRS defines this simply as “when the property, and or, unit(s) are made available to rent (or made available for their intended income producing purpose).”
So if you buy a building and sit on it for a year, there’s no depreciation to claim for those 12 months.
Conversely, if you buy an apartment building and list the units for rent the day after you close - even if tenants don’t move in immediately - your recovery period is in full swing and you’re able to start taking advantage of the depreciation write off.
Rule #3: The Mid-Month Rule
Now that I’ve explained the “placed in service” principle, next on the list is the Mid-Month Rule.
Essentially, the IRS assumes all properties are placed in service in the middle of the month.
It doesn’t matter if you list the unit for rent on January 1st or January 30th, you can only claim 50% of the first month’s depreciation.
Here’s how this plays out:
You buy an apartment building. Your annual allowable depreciation is $10,000.
You place the building in service on April 28th.
The amount of depreciation you’re able to claim for this year is: $10,000 x (8.5 ÷ 12) = $7,083
Closing Note: The same rule applies when selling a property. The IRS assumes that all assets are exited in the middle of the month. Therefore, the same mid-month calculation would apply to the year that you sell.
Rule 4: Mixed-Use Calculation
As previously stated, different types of properties have different recovery periods. Most notably: residential real estate has a recovery period of 27.5 years while non-residential commercial real estate has a recovery period of 39 years.
But what about mixed-use real estate?
How does depreciation work for your typical bodega that has a commercial space at the ground level and apartments above?
You have to break the building up into pieces.
Like this:
First, calculate your building value.
Then, divide the property based upon square footage or unit count (assuming both residential and commercial units are similar in size).
Lastly, apply the proper recovery period to each respective segment.
This is how you will arrive at your segregated annual allowable depreciation.
The various segments of the building will be recovered on their own individual timeline for the duration of ownership.
Here’s an example:
You purchase a 5,000 square foot mixed-use property.
The price tag was $1M. The land was worth $200K and the building value was $800K.
3,500 square feet is residential and 1,500 is commercial.
3,500 ÷ 5,000 = 70% Residential
1,500 ÷ 5,000 = 30% Commercial
Residential Depreciable Basis = 70% x $800K = $560,000
Commercial Depreciable Basis = 30% x $800K = $240,000
Residential Annual Allowable Depreciation = $560,000 ÷ 27.5 = $20,364
Commercial Annual Allowable Depreciation = $240,000 ÷ 39 = $6,154
Rule 5: Partial Rental Rule
When calculating the claimable depreciation of a property, you not only have to dissect the building based upon its composition (i.e. portion of residential units or square footage versus commercial units or square footage), but also based upon its use.
You can’t claim depreciation for any portion of a property that you utilize at your primary residence.
Therefore, you have to subtract the residence portion of the property from the business-use portion of the property.
Like this:
You’re house-hacking a 4-unit apartment building that you own.
You live in one of the units and rent out the other 3.
The total annual allowable depreciation for the building is $10,000.
But because 100% of the building is not being utilized for business or commercial use (i.e. as a rental), you cannot claim all $10,000.
You have to deduct the portion that you’re using as your primary residence.
In this case 3 of the 4 units are in service, which is 75% ( 3 ÷ 4 = 75%).
So the annual allowable depreciation while you’re occupying one of the units is $7,500 ($10,000. x 75% = $7,500)
Rule 6: Residence to Rental Conversion Rule
Typically, your depreciable basis corresponds with the cost of the building at the time of acquisition.
Here’s the normal equation: Adjusted Cost Basis - Land Value = Depreciable Basis (i.e. costs of acquiring the building)
But the math is slightly different when you occupy the property, then convert it into a rental later down the line.
In these scenarios, your depreciable basis will be either:
The Adjusted Cost Basis (Minus Land Value) or
The FMV (Fair Market Value) (Minus Land Value) at the Time the Property Is Placed In Service
Whichever is lower.
For instance, let’s say:
You purchase a single family home for $500,000.
With closing fees, your total cost was $510K.
The land was worth $100,000 (i.e. 20% of the total property value).
So if you were to place the property in service immediately, or shortly after closing, your depreciable basis would be $410,000.
But instead of listing the property for rent, you chose to make it your primary residence.
After living there for 3 years, you then chose to move and rent it out.
But since purchasing the property, the market has shifted.
The FMV of the property is now $450K.
Because the FMV is lower than the adjusted cost basis, we must use the FMV.
To do so, you must first allocate the FMV between land and building.
If land represents 20% of value: Land = $90,000 Building = $360,000
Therefore, the depreciable basis is $360,000.
This rule is especially important for those that invest in real estate primarily for its tax benefits.
Whenever you convert properties from a primary residence, into a rental, you have to account for the potentiality of the asset dropping in value prior to it being placed into service.
Depreciation is real estate’s most touted tax benefit.
Often times, the entire underwriting model and deal analysis is predicated upon the operating profit that these write-offs enable.
But the vast majority of investors only know the bare minimum about how depreciation actually works.
I was a part of the vast majority for years.
And I still don’t know everything under the sun when it comes to depreciation.
But I didn’t stop digging at an inch wide and a mile deep.
I continued to expand my surface area of understanding.
And by doing so, I’ve become a better overall investor in the process.
What you’ll come to find - as I did - is that: you only become the best in one area, after you get better in other areas.
This is the paradoxical path toward perfecting your craft.
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