Our articles on Home Offices Depreciation and Auto Depreciation discuss two of the most common forms of depreciation relevant to Real Estate Agents. Real Estate Agents, Auto Expenses: Bonus Depreciation and Section 179 Expense, covers these depreciation-related topics as they apply to business autos. Our article Writing Off Personal Items Used in Business discusses the depreciation of personal items converted to business use. This article will discuss the basics of depreciation as it applies to other items commonly depreciated by real estate agents. We cover all of these topics in detail in our Real Estate Agent, Tax Cut Library.
We only cover the basics of depreciation for two reasons: First; Deprecation is highly complex. Depreciation has so many methods and rules that the IRS publication covering the topic, Pub 946 - How to Depreciate Property is 114 pages long (and it only covers the basics)! This technical complexity quickly loses the interest of readers, even those interested in the topic of taxation. The second reason we stick to the basics is the frequency with which congress changes depreciation rules. This frequency of change helps tax professionals stay gainfully employed, but it does little to keep depreciation articles, such as this one, timely & correct.
Depreciation Overview: Depreciation expenses an asset over time instead of all at once. Depreciation is reported on Form 4562 Depreciation and Amortization. The basic theory behind depreciation is that some items purchased for business are not consumed (used up) immediately. They last and provide value for more than one year. The cost of these items should, therefore, be expensed over the period they provide value to the business. Such items are called assets, and the depreciation period is called its useful life or its depreciable life.
Asset Value Threshold: Not all assets that last more than one year require depreciation. For example, I have a Bic mechanical pencil I purchased a few years ago in a ten-pack. The entire pack cost a few dollars. As long as I fill it with replacement lead, the pencil works fine. The pencil is an asset, but it seems a little ridiculous to depreciate a fifty-cent mechanical pencil! The good news is I don’t - the IRS agrees – tracking all low-cost assets would be silly. The basic rule (which does not always apply because it’s complicated) is that personal property assets costing less than $500 do not require depreciation. Expense these items in the year of purchase.
In 2016 the $500 threshold increased to $2,500 for most small businesses. The higher limit was created as a safe harbor to clarify some messy (to say the least) capitalization rules and ease the compliance burden of depreciating every asset costing more than $500. To Utilize the $2,500 threshold, however, the business must have a formal accounting policy of expensing assets costing $2,500 or less.
As a practical matter, most realtors and service businesses make few asset purchases in the $2,500 range. For most of these clients, we continue to use the $500 asset cost-limit for depreciation. This policy allows us to more effectively utilize the Section 179 Expense and Bonus Depreciation (discussed in a separate article) to influence income and certain tax credits.
An additional concern with small businesses using $2,500 limit involves tangible personal property tax assessed by the company’s county or state. A policy of not depreciating assets costing less than $2,500 means these assets may not make it to the company’s property tax return. As a result, many jurisdictions require the tracking and reporting of assets costing less than $2,500, regardless of their federal-tax expensing policies.
Asset Depreciable Value: Depreciable value, a term synonymous with “beginning basis,” represents the value of an asset that can be depreciated. The beginning basis of an asset is generally the lesser of its: 1) Cost or 2) Fair Market Value when placed in service. Cost is what it sounds like: it is the price you paid for the item. It also includes sales tax, shipping, and other outlays to make the asset usable for business (such as installation).
Fair Market Value is the amount a disinterested party would be willing to pay for the asset when the business starts to use it.
The beginning basis of an asset purchased and immediately used by the business is nearly always its cost. The distinction between cost and fair market value comes into play when a personal-use item converts to business use. For example, Jill, a licensed Real Estate Agent, purchased a digital camera a few years ago for $1,500. This year, she started to use it exclusively to take pictures of homes. Jill looks online and sees that the current resale value of the camera is $825. Her cost is $1,500, but because the fair market value of the asset is $825, she will only be able to depreciate $825.
Asset Depreciable Lives: The IRS defines the depreciable lives of assets by placing them into what are called asset classes. The most common asset classes (under what is termed MACRS: Modified Accelerated Cost Recovery System) have depreciable lives of 5, 7, 15, 27.5, and 39 years. Most assets are depreciated using MACRS 200% or 150% Declining Balance, which expenses more of an asset in earlier years and less in later years. MACRS Straight-Line, used for real estate and some automobiles, depreciates an asset in equal increments over its class life. Several assets require amortization (AMORT), most easily defined as depreciation for intangible assets.
Here’s a list of asset classes common assets, the depreciation method used, and some common assets that fall into each category.
- 3 Year (AMORT): Computer Software is amortized over 36 months using the straight-line method. Straight-Line method expenses the same amount each month.
- 5 Year (MACRS): Computers and related equipment, Digital Camera & Equipment, Photocopiers, and Automobiles (Click to read Auto Depreciation Article).
- 5 Year (AMORT): Startup costs are amortized over 60 months using the straight-line method. We discuss Startup Costs below.
- 5 Year (MACRS – Straight Line): Vehicles when the owner chooses to switch between actual costs and the standard mileage rate.
- 7 Year (MACRS): Most tools and equipment, Office furniture, desks, filing cabinets, safes, cell phones, and assets that do not fit into another class.
- 15 Year(MACRS – Straight Line): Land Improvements such as sidewalks, roads, fences, landscaping, and shrubbery.
- 27.5 Year (MACRS – Straight-Line): Residential real estate – rental homes for individuals and families.
- 39 Year (MACRS – Straight-Line): Commercial real estate, including the home office.
Startup & Organizational Costs: Startup costs are expenses incurred before the business begins serving the public. Startup costs include investigating company creation, looking to buy an existing business, and any other expense that would have been deductible if the company was open and operational. Organizational Costs are expenses associated with forming a legal entity such as licensing or forming a corporation or partnership.
Most self-employed realtors will have little in the way of startup costs. Many agents, however, erroneously believe that training and testing fees they incur to pass the real estate exam are deductible. As explained in our article, Real Estate Agent, Are License Training and Exam Fees Deductible, these costs are not deductible.
The year a business begins, it is allowed to deduct up to $5,000 of Startup and Organizational costs on its tax return. Any remaining amounts are amortized over 180 months (fifteen years). Deducting and amortizing these costs require an election by the taxpayer. Deducting and amortizing Startup Costs and organizational costs is made by claiming them on a timely filed return, including extensions. No separate election statements are required.
Bonus Depreciation and Section 179 Expense: There are two other ways to write off the cost of property Bonus Depreciation and Section 179 Expense. Bonus Depreciation allows businesses to depreciate a set percentage of qualifying assets (currently 100%) in the year of purchase. Section 179 Expense enables owners to expense a chosen amount of an asset’s cost in the year of purchase. Bonus Depreciation and Section 179 Expense are great tools to reduce taxes and influence income. They do, however, further complicate depreciation. For more information, please read our article on Bonus Depreciation and Section 179 Expense.
Notes on Depreciation: As mentioned throughout our article series and in our Real Estate Agent Tax-Cut Library and Broker Edition, depreciation is complicated. The error rate on self-prepared returns that include depreciation is exceptionally high. We share the basics but recommend that real estate agents and business owners who are depreciating assets hire a professional to prepare their tax returns. Regardless of whether you prepare your own return or hire a professional, here are a few items you should keep in mind about depreciation.
- Depreciation Requires Tracking: Depreciation claimed in one year will impact the return of the following years until the asset is sold or disposed of. You must, therefore, track depreciation from year-to-year. Agents who prepare their taxes should use the same software each year and import the prior year’s return data. If you use different software from one year to the next, you will need to manually enter each asset’s cost and previous-year(s) depreciation. Failing to do so is a common mistake that creates errors on current and future tax returns.
- Depreciation Creates a Gain or a Loss: The sale of a business asset creates a taxable gain or a deductible loss. As an asset depreciates, its basis declines. This reduced basis is used to calculate profit or a loss upon sale.
Let’s revisit the example of Jill and her camera. She purchased it for $1,500, but it was only worth $825 when she started to use it for business. So, Jill’s beginning basis was $825 (the lower of cost or fair market value). She depreciates the camera for two years, and claims $454 of depreciation over that period, $206 in year one and $248 in year two. Her remaining basis (called adjusted basis) in the camera at the beginning of the third year is $371 ($825–$454=$371). If at the beginning of the third year, Jill sells the camera for $500, she will have a taxable gain of $129 - the $500 sales price minus the camera’s remaining basis of $371.
If Jill sold the camera for $300 instead of $500, she would have a deductible loss of $71 - the sales price of $300 minus the camera’s $371 basis.
- Depreciation Can Be “Recaptured:” The portion of a taxable gain that created by previously-deducted depreciation is taxed at a higher rate than the long-term capital gain rate. This higher tax rate is required because depreciation expense reduces the owner’s taxable ordinary income, not capital gain income. Depreciation recaptured on real property (real estate) is taxed at a 25% rate. Gains recaptured on private property are taxed at the taxpayer’s marginal (ordinary) income tax rate.
For example, John owns a rental property.His original basis in the property is $100,000.He holds the property for several years and claims $10,000 in depreciation while owning the rental.His adjusted basis in the property is now $90,000 ($100,000 - $10,000 = $90,000).If he sells the property for $110,000, John will have a $20,000 taxable gain ($110,000 - $90,000 = $20,000).Because depreciation (that he was able to deduct from regular income) created $10,000 of the $20,000 gain, it is taxed at 25% as recaptured depreciation.The remaining $10,000 is taxed as a long-term 15% capital gain.
- Depreciation is Not Optional: If a business owns a piece of property that requires depreciation, it cannot forgo the deduction. The IRS will treat the asset as though it was depreciated, reducing the asset’s basis upon sale - potentially generating recapture when there was no deduction.
Take Away: Depreciation is a significant but complicated deduction. Depreciation is not optional. The depreciable basis of an asset is the lower of its cost or fair market value when placed in service. Depreciated reduces the basis of an asset, generating a gain or loss upon its sale or disposal. A sale-generated-gain can create depreciation recapture and higher taxes. Depreciable assets must also be tracked year-to-year and generate future taxable events. These complications are the reasons we recommend business owners and real estate agents hire a tax professional to prepare their tax returns.
Summary and Invite: We hope this article helped you to understand the basics of depreciation as it applies to Real Estate Agents. If you’d like to learn more about cutting your most significant expense, TAXES, check out our Real Estate Agent Tax Cut Library. The Real Estate Agent Tax Cut Library includes over eight hours of video broken into twenty-nine searchable volumes and covers every possible deduction a Real Estate Agent can take on their tax return. Our Broker Version will help your entire agency cut their taxes! We also invite you to browse our courses.