For today’s Tax Strategy Tuesday, I’ll be sharing a trick landlords and small business owners with real estate and capital equipment (like vehicles and machinery) can use to lower their tax bill or increase profits: accelerating depreciation deductions.
The Strategy in a Nutshell
To explain the tax benefit of accelerated depreciation, it’s important to first understand what accountants mean when we use the word “depreciation”—because it’s probably not what you think.
What is “depreciation”?
So, here’s a weird thing: when accountants talk about “depreciation,” we’re talking about a number that has nothing to do with an asset losing value. I know, this sounds like nonsense. But let me explain.
If a taxpayer purchases an expensive asset that they’ll (1) use over several years to (2) generate revenue (such as a building purchased to rent to tenants), accountants don’t subtract the cost of the asset from income the year the purchase is made. Instead, we break up the cost of that asset into pieces and subtract a piece from income each year over the several years the taxpayer uses the asset to generate revenue.
The number of pieces the cost gets broken into depends on the type of asset the taxpayer invested in and how long the IRS thinks the asset is likely to last. For example, residential real estate is broken up over 27.5 years. Nonresidential real estate is broken up over 39 years. And the cost of other assets (e.g., appliances, cars, computers) is broken up into larger pieces over fewer years.
For reasons that aren’t really clear (at least to me), the convention is to label this expense as “depreciation” on the profit and loss statement. But that’s not really right—the accounting department did nothing to determine whether the asset in question lost value. Instead, this expense should really be labelled something like, “this year’s fraction of the cost of assets we bought some number of years ago.” It’s clunky, but it would be a much less confusing label.
Why Accelerate Depreciation?
So, why would a taxpayer want to accelerate depreciation deductions? Well, two reasons.
First, you can sometimes time an accelerated depreciation deduction to occur in a year with a big spike in ordinary income, thus avoiding a higher-than-normal tax rate.
Example: A high-income taxpayer has nonqualified employee stock options he wants to exercise before they expire. But he’s leery of recognizing so much ordinary income in one year due to the progressive rate structure of the U.S. income tax code. What’s more, he may predict that tax rates on ordinary income will be lower in the future than they are now. One idea for this taxpayer? Invest in a new real estate activity or small business and use a depreciation acceleration strategy to add a large deduction to his tax return in a year when his income and tax rate are otherwise very high.
A second, more abstract, but similarly lucrative benefit? If you can get out of having to wait several years to subtract the full cost of your investment from your income—in other words, if you can subtract the entire cost in the first year, or first few years, you use the asset—you end up with more money in your pocket than you would have otherwise.
Why? Because of the time value of money.
Assuming your tax rate stays constant over the life of your real estate investment, accelerating when you claim the deduction for the cost of the investment won’t lower your lifetime tax bill on paper. But remember that for the years you delay paying the tax, you can instead keep the money that would have gone to the IRS in an investment that earns you a return. Maybe you reinvest that money into your business, and so support additional growth in your firm. Maybe you invest it in an index fund. Or perhaps you just pay down a loan more quickly than you would have otherwise.
Possible Tax Savings
Taxpayers see an immediate reduction in income taxes in the year they deduct depreciation.
For example, if a taxpayer’s return includes a $100,000 deduction and her marginal tax rate equals 40 percent, the depreciation deduction likely lowers that year’s tax bill by $40,000.
Calculating the true savings of the accelerated depreciation, however, requires more work. The calculations also require additional information.
To keep the numbers simple, however, if a taxpayer saves $40,000 in taxes all at once rather than, say, $4,000 a year over ten years, that might deliver a time value of money benefit somewhere between $15,000 and $20,000. (I use a 15 percent annual discount rate to make this calculation.)
And then if a taxpayer can use a $100,000 deduction when the tax rate equals 40% rather than 20%, that obviously saves a large amount, too. In this simple example, it saves $20,000.
Turbocharging the Strategy
For much of the property a taxpayer depreciates, tax laws already allow for accelerated depreciation that frontloads depreciation in the early years of an investment.
Often taxpayers, for example, can use a Section 179 election to expense as much as roughly $1,000,000 of the cost of the personal property in the year the asset goes into service. (That million-dollar limit adjusts annually for inflation. In 2021, for example, the Section 179 limit is $1,050,000. Also note that a taxpayer’s income and other asset purchases factor into the maximum Section 179 deduction.)
Most taxpayers can also use bonus depreciation to immediately expense 100 percent of the cost of assets placed into service in 2021 or 2022 if the assets’ recovery period equals 20 years or less.
Finally, for situations where Section 179 and bonus depreciation don’t give a taxpayer a highly accelerated depreciation deduction? No problem. Three other big tricks exist for turbocharging depreciation deductions. One is to take advantage of the qualified improvement property rules, which relax the rules for when someone can use bonus depreciation. Another is to do something called a “cost segregation study,” which essentially transforms real property into personal property. And a third strategy is to use something called the “179D deduction,” a green building incentive that might be revamped in the Build Back Better bill (i.e., the reconciliation bill).
You’ll want to confer with your tax accountant. You likely need their help to assemble the right depreciation choices that save you taxes and generate time value of money benefits.
But know that these tricks all achieve the same fundamental thing: more of an asset’s cost is subtracted from taxable income earlier in the asset’s life. And possibly more of the asset’s cost is deducted in higher-income years.
Limits to the Strategy
The big caution taxpayers need to be aware of is that Congress has put complex rules into the tax code that limit taxpayers’ ability to deduct large losses from real estate and similar investments. Specifically, four loss limitation regimes to be aware of are the outside basis limitation rules (relevant for investors in partnerships and S corporations), the at-risk rules, the passive activity rules, and the excess business loss rules.
One can often sidestep these rules, but most taxpayers need the help of a skilled tax adviser to do so. And the taxpayer will need to have good recordkeeping to support claiming the loss. For example, if a taxpayer’s ability to claim a large loss rests on meeting the definition of a “real estate professional,” she ought to keep a detailed log of the hours she spends on the activity to prove she really meets that definition.
Another thing to keep in mind? A taxpayer should exercise caution when using accelerated depreciation for cars, boats, and planes or for property that is of a type often used for entertainment, recreation, or amusement. The reason? This property, called “listed property,” creates trouble for taxpayers if they happen to later convert the property from business use to personal use.
Which Taxpayers the Strategy Works Best For
Accelerated depreciation works best as a tax saving strategy for landlords and small businesses considering a large investment in real estate or significant capital assets (like vehicles, equipment, and machinery) and for taxpayers with an unusually high-income year.
Accelerated depreciation works best as a time-value-of-money strategy for investors and entrepreneurs able to invest tax savings in a venture that delivers a high rate of return. So small business. Or a leveraged real estate investment.
Other Information Sources
The IRS provides a great publication about how current depreciation rules work here: Publication 946: How to Depreciate Property.
If you’re interested in an example of how to avoid the loss limitation rules I mentioned earlier, we published an earlier post about the vacation rental strategy in November. We also have a post on the real estate professional rules, another strategy to allow losses.
Finally, taxpayers likely need a tax accountant’s help to maximize the benefits of accelerating depreciation. So do ask your tax advisor to consider these issues. And do give them both the time and the information they need to come up with smart recommendations. Finally, this plug for our accounting firm: If you don’t have a tax advisor who can help with this sort of stuff? You can contact us here: Nelson CPA.