Depreciation in real estate is a tax benefit that allows you, as an investor, to deduct the cost of purchasing and improving a rental property over its useful life. The IRS stipulates a period of 27.5 years for residential real estate.
Imagine investing in a multifamily property valued at $1 million, excluding the land value. (Excluding the land is crucial because land does not depreciate; it doesn’t wear out or get used up over time.) However, the building structure and improvements do.
With a depreciable value of $1 million, your annual depreciation deduction would be approximately $36,364 ($1,000,000 / 27.5 years).
If the property generates $120,000 in rental income and has $40,000 in other expenses, your net rental income would be $80,000.
However, after applying the depreciation deduction, your taxable rental income reduces to $43,636, resulting in significant tax savings as your tax liability is calculated on this reduced income.
As a Limited Partner (LP) in real estate investments, you typically participate as a passive investor. This means you provide capital but do not take part in the day-to-day management of the property. Despite your passive role, you receive a share of both the property’s income and its associated tax benefits, including depreciation.
The depreciation expense reduces the property’s taxable income. This reduced amount is then distributed to you in proportion to your investment.
For example, if you have a 10% stake in a property that generates $100,000 in rental income and claims a $10,000 depreciation expense, your share of the income would be $10,000 ($100,000 * 10%), and your share of the depreciation would be $1,000 ($10,000 * 10%).
Consequently, you would only pay taxes on $9,000 of income from the property, not the full $10,000.
This demonstrates how you, as an LP investor, can benefit from depreciation, utilizing it as a tax shelter to reduce your taxable income and, consequently, your tax liability.
In value-add scenarios, where properties are improved, leading to increased rents, depreciation serves as a cushion, helping to mitigate the tax impact of the increased income and further highlighting the importance of this tax benefit for you as an LP investor.
Remember, it’s crucial for you to consult with a tax professional to ensure they are correctly applying depreciation and maximizing your tax benefits! Need tax advice? I highly recommend Yonah Weiss!