In 2021, the IRS made effective the bonus depreciation, enabling investors to deduct their investment in a multifamily deal from their taxes to offset other capital gains. However, this bonus depreciation is phasing out, having reduced to 80% in 2023, and will continue to reduce by 20% per year. This means in 2024 it will be 60% through 2026 at 20%.
But don’t worry! There are other depreciation options from these investments you could receive. Let us learn about them!
What is Deprecation?
In real estate, depreciation is the reduction in the value of a property over time due to wear and tear or obsolescence. The IRS allows property owners and investors to depreciate the value of the property each year, which reduces the its taxable income and the investors’ tax liability.
Setting aside the Bonus Depreciation, here are some additional depreciation options available for real estate, including multifamily projects.
Straight-Line Depreciation
This is the most common option. It allocates an equal amount of the property’s cost over its useful life. For properties like multifamily units, the useful life is generally considered to be 27.5 years, but remember syndications typically last 3 – 5 years.
Declining Balance Depreciation
Deducts more in the earlier years when the property is depreciating faster, and less in the later years. This is done by applying a higher depreciation rate to the property’s adjusted basis (cost minus accumulated depreciation.) This way, you can get bigger tax deductions sooner.
MACRS Depreciation
The Modified Accelerated Cost Recovery System (MACRS) combines the above two methods for multifamily properties. It establishes a depreciation schedule that leverages the Declining Balance method initially then switches to the Straight-Line later when it provides a larger deduction. This switch is known as the “crossover point.”
Units of Production Depreciation
Based on the actual usage of the property. It bases the depreciation on the number of units or the square footage that is rented out during a specific period. The more a property is used or rented, the higher the depreciation for that period.
Component Depreciation
Multifamily properties have different components with varying useful lives. For instance, the roof will have a different useful life than the appliances. With this method, each component is depreciated separately based on its estimated useful life.
Summary
Here are on-liner descriptions for each deduction option we covered, which should be easier to remember now that you understand the differences.
- Straight-Line: Consistent and equal deductions.
- Declining Balance: Higher dedications earlier, lower deductions later.
- MACRS: Declining Balance first, switch to Straight Line later.
- Units of Production: Varied deductions based on occupancy rate.
- Component: Itemized deductions of the property’s components.
Performing Cost Segregation Studies can also help accelerate deductions from depreciation.
Do I Get to Choose My Own?
The depreciation options are typically defined in syndication’s operating agreement put together by the Sponsoring Team. Limited Partners (LPs) do not have direct control over the specific depreciation options used for the investment.