Tax Strategies to Maximize Your Depreciation Deduction

According to a study recently released by the National Association of Realtors, 23% of homes purchased fall into the category of investment property. Most people understand that rental properties can provide monthly income and build wealth through equity pay down and appreciation. However, most people do not completely understand the two things that tip the scale to make real estate investing the fastest and most secure investment: leverage and depreciation.

Today, we're going to take a closer look at depreciation. Let me start by saying that I am NOT a certified public accountant and that it is imperative that if you are investing in real estate that you have a great accountant that either works with investors or better yet owns investment property himself. Please consult your CPA. This article is meant to give you a list of questions to take with you when you speak to him or her. If they seem very close minded about all of these strategies, then I would suggest getting a second opinion.

Depreciation is a powerful tax savings tool that the IRS gives us. IRS Tax Code is written heavily to encourage and support real estate investing, but you have to know what those benefits are and how to use them. You may even have to ask your CPA to educate him or herself on your behalf.

The IRS defines depreciation as an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property. Another way depreciation is defined is the systematic and rational allocation of the acquisition cost of an asset, less its estimated salvage value or residual value, over the assets estimated useful life.” Simply said, it’s a way of allocating a portion of the cost of an asset over the period it can be used.Rather than getting one large deduction when you purchase a property, the IRS allows you to distribute that deduction over time.

Types of Properties According to the IRS

When it comes to real estate, the IRS considers three types of property:

  1. Land
    The land itself is the only type of property listed above that cannot be depreciated. The amount of the full value of the property that is attributed to the land versus land improvements, personal property and buildings or structures can be determined by the property taxes. The property tax assessment will provide the total assessed value as well as the land value and the land improvements value separately.
  2. Land Improvements
    Land improvements include the buildings, structure, landscaping, sprinkler systems, site lighting, paving…basically any improvement that has been done to your piece of land.
  3. Personal Property
    A common way that I have heard this explained is if the tenant can steal it without the use of power tools, it's personal property.

Useful Life

These are the three categories that you can depreciate over their “useful life”. Useful life is “an estimate of the average number of years an asset is considered useable before its value is fully depreciated. The following is list is straight right out of IRS Publication 527: Residential Rental Property:

5-year property:

  • Computers and Peripheral Equipment
  • Office Machinery (typewriters, calculators, copiers, etc.)
  • Automobiles, and Light Trucks
  • Depreciation is limited on automobiles and other property used for transportation and property of a type generally used for entertainment, recreation, or amusement. See chapter 5 of Pub. 946.
  • Appliances
  • Carpeting
  • Furniture

7-year property:

  • Office furniture and equipment (desks, file cabinets, and similar items)
    Any property that doesn’t have a class life and that hasn’t been designated by law as being in any other class.

15-year property:

  • Roads
  • Fences
  • Shrubbery (if depreciable)

27.5 Year Residential rental property:

Any real property that is a rental building or structure (including a mobile home) for which 80% or more of the gross rental income for the tax year is from dwelling units. It doesn’t include a unit in a hotel, motel, inn, or other establishment where more than half of the units are used on a transient basis. If you live in any part of the building or structure, the gross rental income includes the fair rental value of the part that you live in.

Other Requirements

The overall property also has to meet some other criteria defined by the IRS as well including:

* You own the property.
* You use the property in your business or in an income-producing activity.
* The property has a determinable useful life.
* The property is expected to last more than one year.

Depreciation

Depreciation starts when the property is ready to be occupied. You do not have to wait til it is actually rented to start your depreciation. Depreciation can continue even if the property is unoccupied for a period of time. Depreciation ends either when you have reached the 27.5 years or you sell the property.

Cost Segregation

Cost Segregation is a process allowed by the IRS. It is analyzed by a replacement value standpoint, not just a simple allocation or square footage allocation standpoint. It comes in the form of a report. These are called Cost Segregation Report or Fixed Asset Detailed Report or Fixed Asset Inventory.

What this allows you to do, is in the future when you incur improvements for your property, you will have the detail necessary in order to take a write off for the disposition of any assets that you retire during those improvements. Let me give you an example.

You had a cost segregation down on your property and you broke out the HVAC system. After 5 years of owning the property, the HVAC system needed to be replaced. In that same year that you replaced the HVAC system, you can take the remaining 22.5 years depreciation on that HVAC system. This will help the owner tremendously with the costs of large repairs and improvements.

Bonus Depreciation

The Tax Cut and Jobs Act of 2017 increased the bonus depreciation to 100% for assets new and used properties acquired before September 27, 2017. What this means is that you can take 100% Depreciation on all 5, 7 and 15 year assets in year 1 to offset your purchase costs.

Is Cost Segregation Worth It?

My real estate investment strategy is long term holds. My belief is that I never want to sell a property unless it is through a 1031 exchange to trade up to a larger multi-unit building. I think there is possibly one strategy where you might not realize the benefits of purchasing a cost segregation report. If an investor purchases a fixer-upper, puts quite a bit money into improving the property in the first year and ends up selling it before realizing the total tax deduction for the improvements.

Suspended Passive Losses

The IRS allows you to carry forward your suspended passive losses year after year until you can use them or you sell the property. If you haven't been able to use all your losses prior to selling, then you can use these losses to offset gains when you sell.

The tax rules provide that you may deduct your suspended passive losses from the profit you earn when you sell your rental property. To take this deduction, you must sell “substantially all” of your rental activity. If you own only one rental property and sell it, then you can take the deduction because that property is your entire rental activity. The same holds trule if you own several properties and treat them each as separate activities for tax purposes. However, many landlords with multiple properties elect to combine them as one activity for tax purposes. In this event, if you own several rental properties and only sell one, you can't take the deduction because you won't have sold “substantially all” of your interest in your rental activity.

In addition, you must sell the property to an unrelated party—that is, a person other than your spouse, brothers, sisters, ancestors (parents, grandparents), lineal descendants (children, grandchildren), or a corporation or partnership in which you own more than 50%. And, the sale must be a taxable event—that is you must recognize income or loss for tax purposes. This means tax-deferred Section 1031 exchanges don’t count, except to the extent you recognize any taxable income. (I.R.C. §469(g).)

Depreciation Recapture

While deprecation allows you to recover costs and reduce your income for a given tax year, when the property is sold the deductions will be recaptured and taxed. Capital gain is the between the net sales price and the adjusted basis. Taking depreciation deductions reduces your adjusted basis.

There are two ways to avoid depreciation recapture taxes. The first is through a 1031 Exchange. The second is to leave it to your children in a Family Trust. You can always access capital held in a property through a cash-out refinance as well. This will not trigger a tax event or affect your basis or property taxes.

Other Things to Consider

If you believe that you have not taken full advantage of depreciation and wish you could go back in time. You can.

Regular amendments can only go back 3 years. This is not a complicated process and should be done if you can realize a savings or a return of taxes paid. However you can also go back in time and amend unlimited returns via a 3115. This is a complicated process that an accountant will charge heavily for, so it only makes sense if you could realize quite a bit of tax savings. If you already took losses every year, then it doesn't make sense. However if you were paying taxes and could realize a substantial refund, it might be worth it.

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