[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
Real estate investors in our community are always seeking ways to maximize their tax benefits. One effective strategy is achieving Real Estate Professional Status (REPS), which allows you to shelter active income, such as W-2 or 1099 earnings. However, many investors just starting out don’t qualify because they either don’t own enough properties to meet the required hours or they’re working too many hours at their day job instead of in real estate. As a result, some choose not to accelerate depreciation on their properties initially and instead wait until a future year when they do qualify. This leads to a common question: Is it possible to accelerate depreciation on a property they bought in the past?
This process typically involves conducting a cost segregation study and filing IRS Form 3115 to change their accounting method. However, there’s been some confusion about whether this is still possible under recent tax law changes. Here’s what you need to know.
Straight-Line vs. Accelerated Depreciation
When you first purchase a rental property, you generally depreciate it using the straight-line method over 27.5 years for residential real estate. This method spreads the deduction evenly over time, providing a consistent but modest tax benefit.
However, once you qualify as a Real Estate Professional, you may want to maximize your deductions by accelerating depreciation. This is done through a cost segregation study, which reclassifies certain parts of the property into categories that can be depreciated more quickly—over 5, 7, or 15 years. By front-loading these deductions, you can significantly reduce your taxable income in the early years.
Using IRS Form 3115 to Change Your Accounting Method
If you’ve been using straight-line depreciation on a property you bought in the past, you’ll need to change your accounting method to take advantage of accelerated depreciation. This is where IRS Form 3115, the “Application for Change in Accounting Method,” comes in. By filing this form, you can retroactively apply a cost segregation study and start accelerating your depreciation without having to amend prior-year tax returns.
Filing Form 3115 allows you to claim a “catch-up” depreciation adjustment, known as a Section 481(a) adjustment, in the current tax year. This can result in a substantial one-time deduction, reflecting the difference between the depreciation you’ve taken and the accelerated depreciation you could have taken under the new method.
Recent Confusion Regarding Changes Under the Biden Administration
Since President Biden took office, there has been some debate within the tax community about whether certain changes might affect the ability to file Form 3115 to switch to accelerated depreciation on previously purchased properties. Some CPAs have suggested that these changes could limit or prevent the use of this strategy, but there is no clear IRS ruling or regulation that explicitly prohibits it as of now.
Many CPAs still believe that filing Form 3115 to change to accelerated depreciation is permissible, provided all other requirements are met. However, this area of tax law can be complex and subject to interpretation, so it’s crucial to consult with a CPA who specializes in real estate before making any decisions.
Why You Need a Real Estate-Savvy CPA
Not all CPAs are well-versed in the intricacies of real estate tax strategies. The rules around accelerated depreciation and REPS are complex, and an inexperienced CPA might not be aware of all the options available to you. To ensure you’re maximizing your tax benefits legally and efficiently, it’s important to work with a CPA who understands real estate inside and out. If you need a referral to one of our trusted partner real estate CPAs, you can find more information here.
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