Many investors want to know the impact of depreciation on private placement investments and also on REIT investment. This blog is for those investors. Through this blog, we will deliver a brief overview of depreciation and its impact on private placement investments and REIT investment. So, go through the sneak peek of the blog to learn more.
What is Depreciation?
Depreciation is the reduced amount of the recorded cost of a fixed asset in a systematic manner. It loses value over time until the value of the asset becomes zero or negligible.
Depreciation is a non-cash expense. So, it reduces the taxable income of property without reducing its cash flow.
Depreciation allows a portion of the cost of a fixed asset to the revenue generated by the fixed asset. As the revenues are recorded with their associated expenses of the accounting period so this is mandatory under the matching principle. It gives a complete pictorial description of the revenue generation taxation.
For example, a property having $2,000,000 gross rents collection, its operating expenses are $500,000, and a depreciation expense of $800,000. The loss for tax purposes is $100,000 ($2,000,000 – $500,000 – $800,000), but still the cash flow is $700,000 produced by the property.
Impacts of Depreciation on Private Placement Investment
Generally, private placements are integrated as partnerships, and at the partnership level, the taxes are not payable by the investors.
Rather, the share of income, deductions, and credits of each partner is “passed-through” to the individual partner via Schedule K-1.
An individual partner has to report the K-1 on his or her individual tax return based on the individual circumstances. Rental income tax is supported by the ordinary tax rate which ranges from 0 – 37%. Generally, the rental income is the combination of depreciation and other operating expenses, and the loss is carried forward to the partner.
Due to these losses the investors fail to pay the taxes on the rental income but they can afford other passive income (e.g. from other rental property investments). Sometimes these losses are carried forward with the investors having passive income in future years which are offset by these suspended losses, or when the investment is sold.
During the sale of the investment the losses are deducted from the investor’s other income and also the losses from that investments are unlocked.
Another disadvantage of depreciation is that the tax rate is recaptured upon sale of the asset up to 25%. And through current and suspended passive losses it can be reduced, or reinvesting the gains into 1031 exchange is the strategy to eliminate depreciation.
Impacts of Depreciation on REITs
The taxes are not incurred from REITs at the trust level as long as they pay at least 90% of their income to shareholders.
The ordinary income tax rate ranges from 0% – 37% which the shareholders have to pay on the ordinary dividends obtained from the REIT. They also receive capital gains tax at a rate of 15% – 20% when REIT makes capital gains distribution. Also, the investors are subject to 3.8% Net Investment Income Tax (NIIT) for having an Adjusted Gross Income (AGI) of more than $200,000 for single and $250,000 for married.
The return of capital usually reduces the shareholders’ cost basis. This return of capital is considered as the entire or the part of the dividend received by shareholders. It denotes the depreciation and other operating expenses passed through on the property K-1s. This is considered non-taxable. Later during selling the property this is taxed as a capital gain.
An example will make it more clear, suppose Denver invests in REIT shares at $20/share. The REIT makes a $1/share distribution to all shareholders. Since REIT had significant losses from depreciation and other operating expenses, the total distribution is considered a return of capital and thus the shareholders’ cost basis in the share is reduced to $19/share ($20 – $1).
But this return of capital is now not taxable, if the shareholder sells the share for $21, they have to pay capital gains tax on the $2 gain, $1 from the return of capital.
Why do the investors receive a Return of Capital?
An investment with value-add faces loss at the beginning as the property is not fully occupied and also the income generated is not enough as the property undergoes renovations. Also, the use of cost segregation studies and 100% bonus depreciation may lead to more losses. Thus an investor buying shares of REIT must be prepared to get a capital return in the first few years of holding shares of the REIT. And the benefit of it is that the dividends are not taxable in the current years but will be taxed later down the line.
The Lilypads Bottomline
Depreciation is a non-cash expense that is affected through the use of cost segregation studies and also by accelerated depreciation methods, which includes 100% bonus depreciation. For private placement investors, the increment in depreciation expense usually affects the rental income from tax and creates passive losses. These losses are deducted against other passive income or sometimes are suspended and carried forward.
And for REIT investors, the value-add component gets merged with depreciation and results in a return of capital rather than a taxable dividend. And in these cases, they don’t have to pay taxes at the beginning but have to pay the capital gains tax at the time of selling the property.