Smart investors continually focus on after-tax returns, asking, “How much of the return will I keep?” The answer is driven by (1) investment performance, and (2) taxes.

Our focus here is on the latter factor, specifically, one of the most powerful tax advantages of investing in private real estate: the ability to take depreciation deductions. We explore how depreciation works for real estate investors, including cost segregation and depreciation recapture. We also discuss how hospitality real estate investments are particularly well suited for depreciation deductions.

Depreciation in real estate investing

The IRS defines depreciation as an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. Depreciation allows for the wear and tear, deterioration, or obsolescence of the property.

The benefits are significant: By lowering your taxable income, you can reduce your tax bill. For many real estate investors, the dollar savings are substantial.

Key consideration #1: Cost segregation

The annual depreciation deduction can be calculated by dividing the asset’s initial value by the number of years in its useful life. The IRS determines standard depreciation periods. For non-residential real estate properties, the standard period is 39 years.

It is possible, however, to depreciate certain elements over a shorter time horizon by completing a cost segregation study. Cost segregation studies involve in-depth analysis of a given project to identify costs that can be reclassified to allow for shorter, accelerated deprecation periods. In non-residential real estate, for example, certain elements can be depreciated over five, seven, or 15 years instead of 39 years.

Some elements may even qualify for first-year bonus depreciation, which allows for a sizeable write-off of certain depreciable assets the first year they’re placed in service. Under the Tax Cuts and Jobs Act of 2017, the deductible amount for qualified property placed in service after September 27, 2017, and before January 1, 2023, is a full 100%. As the benefit phases out, the percentage decreases by 20 percentage points each year until reaching zero in 2027 (unless legislative action is taken).

Say you’ve just invested in a non-residential real estate property with a $5,000,000 cost basis, comprised of $1,000,000 for the land (which can’t be depreciated) and $4,000,000 for the building asset. Without cost segregation, you would claim 1/39^th of $4,000,000 each year as your depreciation deduction. If you commission a cost segregation study, your advisory team can identify multiple items that are eligible for shorter depreciation timelines—and even eligible for bonus depreciation.

Category	Depreciable life	Eligible for bonus depreciation	Without cost segregation study	With cost segregation study
Building	39 years	No	$4,000,000	$400,000
Qualified improvement property	15 years	Yes	$0	$2,800,000
Personal property	5 years	Yes	$0	$800,000
Land			$1,000,000	$1,000,000
Total			$5,000,000	$5,000,000

Key consideration #2: Depreciation recapture

When you sell depreciable property at a gain, you may have to treat all or part of the gain as ordinary income instead of a capital gain. This is how the IRS “recaptures” the benefits you enjoyed by using depreciation to reduce ordinary income taxes during the holding period. You’ll have a gain if the amount you realize from the sale is greater than the asset’s adjusted cost basis. Depreciation lowers the adjusted cost basis.

Let’s consider a simplified example: Say a property is purchased for $1,000,000 and sold for $1,500,000 in the sixth year. During the five-year holding period, depreciation deductions totaled $150,000. The adjusted cost basis is $1,000,000 – $150,000 = $850,000. The gain from the sale is $1,500,000 – $850,000 = $650,000.

Of this $650,000 gain, $150,000 will be treated as ordinary income, as this is the amount of the total depreciation deductions. The remaining $500,000 will be treated as a capital gain.

Benefits of cost segregation and accelerated depreciation

Cost segregation allows investors to secure greater depreciation deductions in the early years of ownership, which can boost after-tax returns. The time value of money also makes it beneficial to take depreciation deductions earlier, given that a dollar is worth more today than in the future.

In addition, some investors may benefit from tax rate arbitrage. Depreciation reduces the amount taxed at ordinary income tax rates during the holding period. For high earners, the top marginal federal tax rate is 37%. When the IRS recaptures the benefits of depreciation, ordinary income tax rates apply—generally, however, the maximum tax rate in this scenario is just 25%.

While cost segregation and depreciation can deliver meaningful benefits, investors and sponsors should be mindful that greater depreciation in the early years—especially bonus depreciation in the first year—lowers the asset’s adjusted cost basis. If the asset is going to be sold quickly, short-term capital gains tax rates may apply, which are significantly higher than long-term capital gains tax rates.

How does depreciation work for passive investors in a private real estate investment?

Most private real estate is purchased via LLCs or limited partnerships. As such, the income, expenses, and tax deductions flow through to the individual investors.

Depreciation expenses are combined with other expenses, which are all subtracted from income to arrive at the limited partnership’s net income or loss. Income or losses are then reported to each limited partner based on ownership percentage. When the asset is sold, any associated gains pass through to the investors in the same pro rata fashion. Schedule K-1 forms detail each investor’s share of these items.

A passive investor’s K-1 may show a loss if the year’s depreciation deduction is greater than the net operating income. What you’re able to do with such a passive loss depends on your personal situation. Generally, losses from passive activities can only be used to offset passive income.

Depreciation and hospitality real estate investments

Different types of real estate properties offer different opportunities to take depreciation deductions. Among the major real estate segments, hospitality offers arguably the greatest opportunity to take large, early depreciation deductions.

Hotels have a substantial number of elements that can be reclassified to shorter depreciable lives of five or seven years—much shorter than the standard 39-year depreciable life. This is due to the number of items that fall into the personal property category, which is usually the shortest time frame for depreciation.

Personal property items in a hotel include furniture, fixtures, fittings, and equipment required for guest rooms, lobbies, restaurants and lounges, kitchens, front desks, and offices, such as:

Carpet	Appliances
Blinds	Furniture
Shelving	Computers
Decor	Plumbing fixtures

To operate successfully, hotels must invest a large amount of capital in these personal property items. In fact, a significant portion of a hotel’s total cost—as much as 30% to 35%—can commonly be written off in the first year. The ability to offset income with depreciation is particularly important for investments in hotels, which are traditionally seen as cash-flowing operating businesses.

Capturing the benefits of depreciation with hotel investments

Private real estate investments offer many potential advantages, including tax benefits. A top tax benefit is the ability to take depreciation deductions—and the fundamental characteristics of hotels position them to offer especially advantageous depreciation dynamics.

While we’ve covered some of the basics here, the intersection of taxes and investments can be nuanced. It is always advisable for investors to consult with experts, including tax, accounting, and financial specialists.

Two of the leading hospitality owners/developers/operators in the country have created the Jali platform to provide access to institutional-quality hotel investment opportunities. To learn more, visit jali.co.