Real Estate Crowdfunding: Understanding Depreciation
Almost all real estate investors have heard of depreciation. In fact, many understand the basics of calculating depreciation. However, when it comes to real estate crowdfunding, investors often get confused as to how depreciation is recorded and passed through to investors. Let’s take a closer look.
Depreciation is a non-cash expense. It represents a tax deduction that allows for the recovery of the cost or other basis of certain property. It is essentially an annual allowance for the theoretical wear and tear and deterioration of the property. It covers most types of tangible property, such as buildings, machinery, vehicles, furniture, and equipment, but is not allowable on land.
Depreciation begins when a taxpayer places property in service for use in a trade or business or for the production of income. The property ceases to be depreciable when the taxpayer has fully recovered the property’s cost or other basis or when the taxpayer retires it from service, whichever happens first. Real estate that is held for rental income as an income producing activity is depreciable.
But to understand how depreciation works in the real estate crowdfunding environment, we need to first understand the crowdfunding structure. Depreciation would be applicable in a real estate crowdfunding “equity” deal as opposed to a “debt” deal. In a typical equity structure, the investor would own shares in a limited liability company (“LLC”) that invests into another LLC that holds title to real estate (an apartment building, shopping center, etc). I would call the LLC that actually holds title to the real estate the “holding” company.
Based on this structure, the investor holds essentially an indirect equitable interest in the real estate and will participate in the financial upside (or possibly downside) of the property itself. As such, the investor is a partner in a partnership structure. So considering this equity structure, let’s take a look at how depreciation is calculated and recorded.
First of all, depreciation is calculated at the “holding” company level, not by the individual investor. The holding company will record depreciation using a straight-line basis over 27.5 years for residential rental property (single family homes, apartment buildings) and 39 years for commercial property (office buildings, etc). A shorter useful life is assigned to items such as appliances and other building assets.
For example, assume that an apartment building is being purchased for $3,500,000. Let’s also assume that the land value is $750,000. We would deduct the land value from the overall purchase price, deriving a depreciable basis of $2,750,000. Since this is residential real property, we would assign a life of 27.5 years and thus calculate annual depreciation of $100,000 ($2,750,000 divided by 27.5 years). This expense is then recorded by the holding company LLC.
Since the depreciation is recorded at the holding company level, the real estate crowdfunding investor does not need to be concerned about recording depreciation. As a result of depreciation expense, net income is lowered and the taxable income from the Form K1 will likely be lower than any distributive cash flow. This is a major benefit to real estate crowdfunding investors.
Depreciation can really be a real estate investor’s best friend. Fortunately, real estate crowdfunding investor’s don’t need to be concerned with any specific calculations. As with any investment, make sure to discuss the tax specifics with a qualified CPA or tax professional so that you understand the tax issues as they relate to your specific situation.
About the Author
Paul B. Sundin is a CPA and tax strategist. He works with clients worldwide on real estate taxation issues, including crowdfunding and real estate syndication. You can find out more information on him by visiting www.sundincpa.com. Should you have any questions for Paul, you can reach him at 480-361-9400. He also provides a free ebook on tax issues for foreign investors called “7 Critical Tax Questions for Foreign Investors in U.S. Real Estate”. You can obtain a copy of the ebook here www.sundincpa.com/foreign-investor-ebook/
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