Seven Proven Depreciation Strategies
By Diane Kennedy, CPA
Why do you want to invest in real estate? There are three main
benefits to real estate investing:
(1)
Cash flow,
(2)
Appreciation, and
(3)
Tax benefits.
When it comes to depreciation, the topic of this Home Study Course,
the focus is on tax benefits. Before we move on to that, though, I
would like to caution you on one thing.
It can be tempting to just buy any real estate because of the thought
that the tax benefits would make up for any poor decision making in
the real estate investment.
Don’t do it.
First and foremost, real estate investment should be about cash flow.
If you don’t have cash flow, you better have a pile of money and a
long term safe and secure source of cash. Otherwise, you are just
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betting that you can hang on to the property until someone who will
buy it from you. And remember it’s a property that doesn’t cash
flow. So, the person who will buy it will be someone who doesn’t
care about cash flow. If it’s not their house or their hobby, it means
they are an investor who doesn’t care about cash flow. There aren’t
many of those.
In real estate terms, that kind of strategy is called the ‘greater fool
strategy.’ You are betting you can find an investor who cares less
about cash flow then you do.
That’s not a plan for long term success.
Or, you could fall into the ‘rising tide strategy.’ This is a strategy that
can come back and bite you too. In this case, the idea is that real
estate values are going up, up, up and no matter what you have to
jump in now before the market gets out of reach. Everything is fine
until it isn’t. Then suddenly you’re stuck with a property whose rent
doesn’t cover the expenses and that is worth less than the debt.
Appreciation is nice, especially if it’s planned appreciation and you
are going to sell. Otherwise, it should be all about the cash flow.
The third benefit, tax, is what this Home Study Course is about. And,
more on point, we’re going to talk about depreciation. The unique tax
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benefit available to real estate is depreciation. It’s a phantom expense.
Unlike a business, you can take a deduction without actually
outlaying cash. And you can plan exactly how and when you want to
take that deduction. There is nothing else quite like it in the tax
world.
This is how the rich use real estate to build assets, create cash flow
and pay a whole lot less in tax.
Three Types of Real Estate Expenses
For tax purposes, there are three types of real estate expenses:
Direct Expenses,
Indirect Expenses, and
Phantom Expenses.
Direct Expenses
A direct expense is an expense that is directly related to the property.
It would include mortgage interest, property tax, real estate tax,
repairs and other expenses that wouldn’t exist if you didn’t have this
rental property.
One tricky part with direct expenses has to do with the question of
whether an expense is a repair or improvement. This has been a tax
issue for years and the IRS finally addressed it with regulations in
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2014. Instead of making it easier, though, it was made a whole lot
harder.
In general, if you buy something, repair something or improve and
the total invoice is under $2,500, you can take an expense for the
repair. Otherwise, certain things must be capitalized and then
depreciated.
The items that must be capitalized are:
Improvements. You must capitalize any expenses you pay to
improve your rental property. An expense is for an improvement if it
results in a betterment to your property, restores your property, or
adapts your property to a new or different use.
Betterments. Expenses that may result in a betterment to your
property include expenses for fixing a pre-existing defect or
condition, enlarging or expanding your property, or increasing the
capacity, strength or quality of your property.
Restoration. Expenses that may be for restoration include expenses
for replacing substantial structural part of your property, repairing
damage to your property after you properly adjusted the basis of
your property as a result of a casualty loss, or rebuilding your
property to a like-new condition.
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Adaptation. Expenses that may be for adaptation include expenses
for altering your property to a use that is not consistent with the
intended ordinary use of your property when you began renting the
property.
You usually don’t have a choice turning an expense that should be
capitalized into a current expense, but you do have a choice on
whether your otherwise depreciable repair expense should be
capitalized. There could actually be a strategy here. That’s because
the capitalized item would be depreciated. And depreciation gives us
strategies.
With the exception of the repair vs improvement possible strategies,
you should always report all of your direct expenses. This is true
even if the direct expenses push you into a loss that ends up being
suspended.
A suspended loss is better than no loss. Report all of your direct
expenses.
Indirect Expenses
Your indirect expenses are legitimate expenses that are deductible
but aren’t directly attributable to a property. Some examples of
indirect expenses could be:
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Accounting
Cell phone charges
Computer
ISP
Software, and
Travel.
Just like with direct expenses, I recommend that you always report
all of your available direct and indirect expenses, even if you can’t
currently take the deduction against your other income. At the least,
they will create a loss that can be suspended for later use.
The one possible challenge with indirect expenses will be with
expenses that really can’t be reasonably linked to an active real estate
business. For example, sometimes I meet people who have spent
thousands, even tens of thousands of dollars, on real estate coaching
or mentorship. Is it deductible?
Maybe.
If you pay for education to get you ready for a new trade or business,
the cost is not deductible. If you already have a trade or business,
education may be deductible. In that case, you need to prove that you
really are in business already and that the education is going to help
you in that business.
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Let’s say you have several properties and you attend a class on
landlord law to help you know what tenant rights are. You’ve got a
deductible expense.
However, if you haven’t bought a property yet and you attend
classes to teach you how to find properties, how to find tenants, how
to manage and a dozen other things, you probably don’t have a
deduction.
You must be in business first.
A client of mine faced an IRS challenge when he took expensive
personal development classes and attempted to deduct those against
his real estate properties. Unfortunately, he handled the initial
meetings himself and made some statements that were later used
against him. This was a case more of audit strategy then whether
there was a legitimate expense or not. Most of the time, personal
development is considered a deduction against a legitimate business
provided it can be shown that this will make you a better leader for
your business.
Phantom Expense
Phantom expense, depreciation, is different. That’s because unlike
the case for direct or indirect expenses, where it’s use it or lose it
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situation in the current year. If you can’t take advantage of the loss in
the current year, you can carry it forward until there is passive
income to offset it or you sell the property. But if you don’t report
direct or indirect expenses in the year they are incurred, you can’t
“catch them up” in subsequent years. You may be able to amend a
previous tax return, but that costs you money, time and increases
your audit risk.
In the case of phantom expenses, you can catch up past depreciation.
You can ignore it. You can accelerate it. It’s available when you need
it. And that’s why out of the 3 types of real estate expenses,
depreciation, or phantom expense, is the one that you can be strategic
with.
Step One: How Much Depreciation Do You Need?
Since we have a number of options when it comes to how much
depreciation you can take, the first step is to determine how much
you need.
What is your current net passive income/ (loss) less direct and
indirect expenses?
_____________
What is your total net carry forward passive loss?
_____________
If the total is passive income, note total here:
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If the total passive equals a loss, note here:
(b) _____________
If total is income, you should continue to determine the amount of
depreciation to take in the current year.
If the total equals a loss, will you be able to take
a deduction against other income?
Y/N
Read the next section “Deductibility” to
find the answer to this question.
Deductibility
If your adjusted gross income (AGI) is under $100,000, you can take
up to $25,000 of real estate losses against your other income as long
as you have active participation. You actively participated in a rental
real estate activity if you (and your spouse) owned at least 10% of the
rental property and you made management decisions or arranged for
others to provide services (such as repairs) in a significant and bona
fide sense.
Management decisions that may count as active participation include
approving new tenants, deciding on rental terms, approving
expenditures, and other similar decisions. If you are married, you
must file as married filing jointly in order to take advantage of that
status.
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A time share does not qualify and neither does ownership in a
limited partnership when you are only a limited partner.
If your adjusted gross income is over $150,000, you cannot take any
deduction unless you or your spouse qualifies as a real estate
professional. The real estate professional (REP) status can be a little
complicated. That’s why there is an entire Home Study Course
devoted to this topic.
If your adjusted gross income is between $100,000 and $150,000, the
amount you can deduct phases out.
Step Two Determine Current Ideal Depreciation
After calculating the estimated income or loss from your real estate
investments after direct and indirect expenses, you then looked at
what it takes to take a current deduction of the loss against other
income (if you have a loss).
If you can take the deduction of real estate loss or you have real
estate income, then the next step is to look at depreciation strategies.
If you already have a loss you can’t take, then the best strategy is
probably to not take any depreciation.
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Allowed or Allowable Depreciation
Before we move on to the rest of the depreciation strategies, I want to
address a lingering myth about depreciation.
The IRS code actually says that when you sell your property, you
must recapture depreciation that is allowed or allowable. That one
phrase “allowed or allowable” created all kinds of heartburn for
CPAs for years. The reading of the code made it seem that if you
didn’t take a depreciation deduction, then the IRS was going to force
you to recapture depreciation you could have taken, even if you
didn’t.
The IRS set that all straight in 2004, over 10 years ago.
The IRS issued Rev. Proc. 2004-11 which permits a taxpayer to make
this change even after the disposition of the depreciable property.
Revenue Procedure 2004-11 allows a taxpayer to change the
taxpayer's method of determining depreciation for a depreciable or
amortizable asset after its disposition if the taxpayer did not take into
account any depreciation allowance, or did take into account some
depreciation but less than the depreciation allowable, for the asset in
computing taxable income in the year of disposition or in prior
taxable years. Because the taxpayer is permitted to claim the
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allowable depreciation not taken into account for this asset, the
taxpayer's lifetime income is not permanently affected by the
"allowed or allowable" rule.
In other words, Rev. Proc. 2004-11 allows the taxpayer to deduct the
unclaimed depreciation even after disposition. With this, the IRS
effectively did away with the “allowable” depreciation rule. As a
result, a taxpayer who has claimed less than the depreciation
allowable for its property will no longer risk permanently losing an
allowable depreciation deduction.
Bottom line, if anyone tells you that you must take a depreciation
deduction because of an allowed or allowable depreciation rule, just
tell them they are over 10 years late to the party.
Depreciation Strategies
High Income, Real Estate Loss Client
A client of mine asked what to do about their real estate. They were
following all the rules, they though. They had bought real estate that
looked like it would eventually go up in value but because they lived
in an area that had high prices it didn’t cash flow.
They still wanted to hang on to it, though, so what could they do to
take the deduction?
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Answer: If they had a loss after just taking the direct and indirect
expenses as deductions, then they should not take depreciation
deductions. That’s step one.
In general, though, they need to look at their criteria for buying
investments. They need cash flow and they need passive income.
Maybe it’s time to sell one of the real estate dogs to free up money
and credit to invest in properties that do actually put money in their
pocket.
Often people who fall into this trap buy property for emotional, and
not financial, reasons. If you want a second house, and can afford it,
then buy it. Don’t try to pretend it’s an investment. If you want to
buy a special house for your kids, then buy it. But don’t try to make it
an investment.
Often the best real estate investment is NOT a house that is your
dream house. That is unless your dream is to have investments that
provide cash flow so you can live a life free from the financial
constraints of a job.
Lesson: Know your numbers. If an investment isn’t cash flowing,
don’t make it worse by adding in depreciation. But, you probably
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also need to think about what are you going to do about these
investments. Is it time to dump the bad real estate investment?
Right Strategy, Wrong Year
The first conversation I had with Dr. Greene went a little wrong. He
was single and knew that he’d never qualify as a real estate
professional. But he was excited to tell me that he was retiring the
next year and would then be able to qualify.
He was also excited to tell me that he had read in one of my home
study courses about the use of a cost segregation study. He had paid
his CPA to learn how to do one and after paying almost $1,000 for the
study, he accelerated and used catch up depreciation to create a
depreciation expense. Of course, his income was high and he wasn’t
a real estate professional, so the whole created loss was suspended. It
was not deductible.
And that’s when I told him that he’d made a big mistake.
You see, the loss was now suspended until he either sold the
property or had real estate income to offset it. Instead, if he had done
that in the year he retired, he could have created a real estate loss that
could be used to offset his other income. If his adjusted gross income
(AGI) dropped below $100,000, up to $25,000 of suspended loss could
be taken in addition to other losses.
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He had the right strategy, but at the wrong time.
That’s why it is so important to first know how much loss you can
use against your other income. Unlike direct and indirect expenses,
you can later catch up depreciation if you didn’t take it. There is no
‘use it or lose it’ rule with depreciation.
Lesson: The smartest strategy in the world might not be right for you,
or at least not right now. Make sure you are working with someone
to create a strategy first and then put it in place.
Real Estate Losses, Now What?
If you have real estate losses that aren’t deductible, now what?
Step One: Don’t take depreciation deduction.
If you still have real estate losses, you will then have suspended
losses. Your question then is, “How can you take advantage of and
use up suspended losses?”
How Can You Use Up Suspended Losses?
What do you do if you already have suspended losses?
First, stop or slow down the bleeding. Stop taking depreciation.
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Step One: Is it time to dump the property?
There could be a lot of reasons to hang on to properties that cost you
cash flow. Most of those reasons are emotional and if you can afford
to spend your money that way, maybe that makes sense. Personally, I
want my real estate to work for me, not the other way around.
But there could be a financial reason to hang on. It may cost you
money you don’t have to sell the property. In that case, hanging on to
the property might be the only option unless you are considering
bankruptcy.
You could also believe that the value will go up on the property and
want to hang on until then to sell.
Or it could be that you’re planning to remodel or change the use to
increase the rents.
If at the end of this, and after taking a good hard use at the real
reason you’re hanging on to a non cash flowing property, you decide
to hang on to it despite the loss, read on.
Step Two: Could the property actually be a business?
If you have a property that you hold for a short term and provide
substantial services, you have a real estate business. That means the
loss is most likely deductible.
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A couple came to me for a strategy. They had high income and real
estate losses. In their case, they had a very specific plan to sell high
dollar properties in a few years and felt it was worthwhile to hang on
to the properties until they were ready to sell.
Meanwhile, though, they’d love to find a way to take a write off on
the real estate.
After a bit of a conversation about the properties, we discovered that
these were actually vacation rentals. Housekeeping was included and
the average stay was less than a week. It meant the property qualified
as a business and, as such, the real estate losses were deductible as
business losses!
They had to have active participation, which was an easier test, and
they had to have basis in the property. In their case, they had
invested cash (equity basis) and had signed for the loans with
personal guarantees. That meant they also had debt basis. It was
enough to cover the losses on the properties.
With this simple change in reporting, they now could take the loss
against other income.
Step Three: Suspended Passive Loss Stockpile
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What if your suspended passive losses are stockpiling?
If you’ve been reporting real estate losses for a while and haven’t
been able to deduct them, then you’ve got a stockpile of suspended
losses.
What do you do now? There are actually 3 strategies to use up
suspended losses.
(1) Buy property that will create passive income. In fact, when you
buy your real estate that cash flows, don’t take the depreciation
deduction. That will increase the passive income. The
suspended losses can offset the passive income.
(2) Sell the property with the suspended loss. If you sell a property
that has a suspended loss, the suspended amount increases the
basis. That means you will have less capital gains income. You
have to recapture depreciation at a flat rate of 25%, which
means that if you continued to take depreciation even though
you had suspended losses, you’ll pay more tax in the end. The
capital gains tax rate is lower than the depreciation recapture
tax rate.
(3) Get your adjusted gross income (AGI) below $100,000 and you
can start using up your suspended loss up to offset other
income at a rate of $25,000 per year.
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In general, though, the idea is to not have suspended real estate
losses. If you have suspended real estate losses, it’s like sitting on
money that doesn’t give you any interest. If you want your money to
work for you, like I do, then don’t leave it sitting idly somewhere. If
you already have suspended loss, reduce or eliminate the
depreciation you take so you don’t increase the problem.
If you still have losses even without depreciation, you have a bad
investment. That would be what I would focus my attention on. How
do you turn that bad investment into a good investment?
Strategy Always Starts Here
Strategy always starts with two things: Where are you now? and
Where do you want to be?
The strategy will help you get from one place to the other. In the case
of depreciation, you need to know what your real estate income, net
of direct and indirect expenses, is. That’s the starting place. And then
you need to know what the idea amount of depreciation to take will
be. Can you make use of a real estate loss? Do you already have
suspended losses to use up? Do you plan to be a real estate
professional soon?
Don’t just jump into implementation of what sounds like a good idea.
What seems like the best idea implemented at the wrong time or in
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the wrong circumstances isn’t really the best idea and can be very
expensive.
Tax Strategies for Real Estate Income
Let’s say that after the direct and indirect expenses you still have
taxable income. That’s great. In that case, the next question is
whether you also want to (and can) offset other income. Your goal
here is to find out how much depreciation expense you can use.
Once you know that number, calculate depreciation under the most
common depreciation strategy. A portion is allocated for land, which
is not depreciable, and the rest is real property, depreciated over 27.5
years if it’s residential or 39 years if it’s not. Lately the IRS is getting
a little picky on the valuation for land. You start with the actual fair
market value of land. It’s not some magic formula for the percentage
of the total basis like you might have used incorrectly in the past.
Now, they want to see that you use the actual fair market land value
at the time of purchase.
After that, the rest is depreciated as real property or you can break
out the personal property components with a Cost Segregation
Study.
When to Use a Cost Segregation Study
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If you can handle still more depreciation, it might be time to consider
a cost segregation study. We’re going to cover this in more detail next
month and have a sample template. The IRS has recently created an
audit guide specifically on cost segregation studies. And,
unfortunately, some companies are using that fear tactic to charge
huge fees. You do have to follow the guidelines, but the good news is
that there is no reason why you can’t do your own cost segregation
study. We have a Cost Segregation Home Study Course
The Cost Segregation Study allocates the basis from longer-term
property to shorter term property for some categories of the
property. It doesn’t create new depreciation; it accelerates or frontend loads a portion of the depreciation.
If you make use of accelerated depreciation, you will also need a
strategy to replace the depreciation as time goes on. After about the
sixth year, you will have a lot less depreciation and that means you
may have taxable real estate income. To avoid that, we usually
recommend that you plan to buy additional real estate every five
years.
There is one more benefit with a Cost Segregation Study if you’ve
had property for a while. You can catch up the depreciation.
Catch-up Depreciation
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This is the strategy that Dr. Greene used, but in the wrong year. He
had property that he’d owned for a number of years. Let’s just use
one of those properties as an example.
Property #1: Basis $150,000
There had already been $30,000 that had been allocated to land. The
$120,000 remaining basis had been allocated for 10 years. The total
accumulated depreciation was $43,636. The study showed that
$30,000 could be allocated as 5-year property. That meant that the
$30,000 would have been already depreciated since the property had
been owned for 10 years. The depreciation associated with that
$30,000 had totaled $10,909 at the 27.5-year rate. But at the new 5year rate, it would have all been depreciated. So, the difference
($30,000 - $10,909 = $19,091) of $19,091 is a one-time depreciation
expense.
This catch up depreciation is reported on a special form, Form 3115,
and filed in the year in which you catch it up.
The strategy here is that you take advantage of this catch-up
depreciation in a year when you either have a lot of real estate
income you can use to offset or you qualify as a real estate
professional and can use that loss to offset your other income.
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If you use your catch-up depreciation too fast, like Dr. Greene did,
you’ll end up creating suspended losses, which tie up potential tax
savings.
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