What’s the single, biggest benefit of accelerating your depreciation? It gives you the ability to directly lower income—and thus tax due—without outlaying ANY additional cash.
Since depreciation is simply the systematic expensing of your real estate asset, you do not have any additional cash to shell out as you expense this item. You already paid for it or are paying for it through your loan payments. Those payments are not affected by the rate you depreciate the property.
In other words, servicing the loan and depreciating the asset are two parallel accounting concepts that do not intercept. Therefore, you can increase your cash flow in the years your dollar has the most buying power. Now, that’s a perk!
Why Would You Want to Lower Tax in the Short Term?
In a nutshell, your deduction is worth more today than it will be tomorrow. This is the basic concept of inflation. Since inflation erodes the value of a dollar over time, so does inflation erode the value of a deduction. In total, you will depreciate the entire capitalized cost of your residential real estate asset over time. The deduction amount, in total, will not change so as the value of the dollar decreases due to inflation, the value of this fixed deduction is diminished. Accelerating depreciation allows you to frontload the expense in the early years before the value of that deduction has eroded instead of taking it in a drip fashion over a very long time horizon.
In addition, when starting out, many businesses need extra cash flow to launch operations and grow. Increasing cash flow today can be a better option than taking out an additional loan to make ends meet in the early years, without paying interest!
Why Would You Not Want to Lower Tax in the Short Term?
Every coin has two sides. Therefore, let’s consider the reasons why you would not want to accelerate your depreciation in the early years.
If you are generating a loss with the regular drip fashion, straight-line depreciation method, you will not gain an immediate benefit to accelerating expenses. Excess loss will just carryover each year until it can be utilized.
If you expect your tax bracket will be a lot higher in the next five or six years, then accelerating your depreciation now may not be the most prudent approach. If this is the case, you can wait to execute until the year accelerating your depreciation is needed. At that time, all the prior year’s additional depreciation will be brought forward into your current tax year and thus provide a “pop” of expense in the tax year your tax bracket has spiked.
Know Your Options
In summary, analyzing your options and tax situation is key to knowing when to accelerate your depreciation. When in doubt, be sure to talk to your CPA for a second option.
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