4 Depreciation Tax Mistakes Investors Need to Avoid

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If you are someone who invests in long term rentals, you probably already know how depreciation can be your best friend when it comes to paying less taxes.

What you may not know is that as investors, we can also make some pretty big mistakes when it comes to taking depreciation for our real estate. In today’s blog, I wanted to go over some of those common depreciation mistakes that real estate investors make.

Before we get to the mistakes however, let’s take a step back to discuss what depreciation is.  Simply put depreciation is a paper write-off. What this means is that we are taking a tax deduction on our rental properties when we may not have suffered any actual loss on the property.

Depreciation, under the IRS definition, is “a tax deduction that allows a taxpayer to recover the cost of a property over time. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.”

So if you purchase a property for $100,000, and assuming the depreciable building is 80% of the purchase price, then you are generally able to depreciate $80,000 of the purchase price over the life of the rental. This results in a tax deduction each year that can be used to offset your rental income.

What we as investors love about depreciation is that this deduction is available to you regardless of whether the property actually increases or decreases in value. This means that even if your property appreciated in value and is now worth $130,000, you are still able to write off your depreciation based on what you purchased it for.

Another important thing to understand about depreciation is that the amount you write off is not dependent on how much money you put down to purchase the property.

Rather it is based on the purchase price of the contract. For example, on a $100,000 property, you take the same depreciation expense whether you put 20% down or if you put zero money down. This means that it is possible to use depreciation to get tax write-offs without any cash out of pocket.

Now that we talked about how depreciation can be used to help us save on taxes, let’s talk about the four most common depreciation mistakes that we need to watch out for a real estate investors.

1. Depreciation is Not a Choice

Very often we come across taxpayers who either chose not to take depreciation (due to bad advice) or simply didn’t know they can take depreciation (again, due to bad advice).

It is important to know that depreciation is not a choice and if you are eligible to take it, you must take the tax write off. If your rental is eligible for depreciation but you choose not to take it or forget to take it, the IRS will still assume it has been taken and when your property is sold you may end up paying taxes on depreciation recapture that you never received a benefit for previously.

Related: Real Estate Depreciation: A Deeper Look

The good news is that if you have not taken your allowable depreciation in the past, there are ways to rectify that problem with amended tax returns to claim what you have previously lost.

2. Recapture is Not the Enemy

Now you may be thinking why in the world would someone choose not to take depreciation?

Well, one of the more common reasons I hear is that people are afraid of depreciation recapture. So what exactly is depreciation recapture? Let’s go over an example: if you take a depreciation deduction for $5,000 today, you may need to pay taxes on that $5,000 if you were to sell your property at a gain down the road.

Sometimes people are afraid of taking depreciation simply because they don’t want the possibility of having to pay taxes on it later. Here are three reasons why this thought process is flawed:

  1. Depreciation is required and not a choice. Choosing not to claim depreciation does not protect you from recapture down the road.
  2. If you ultimately sell your property at break-even or at a loss then you generally do not need to worry about recapture taxes.
  3. Even if you do sell your property at a gain and need to pay recapture taxes, doesn’t it make sense to pay taxes years down the road rather than to pay taxes today? You would not want to prepay the next 20 years’ worth of taxes today would you?

3. Maximizing Your Depreciation

There are lots of different ways to calculate depreciation and it is somewhat rare that I see a tax return with depreciation done in a way that accelerates the depreciation deduction strategically.

Most of the time what I see are investors who depreciate their rental property with two components: land and building. Depending on the investor’s tax profile, this could hurt the investor when it comes to depreciation write-offs.

Most rental properties have many more components than this. There may be appliances, parking structures, landscaping, furniture, fixtures, and much more.

These items can be depreciated much faster than land and building. This concept of identifying the different components and accelerating the depreciation write off is known as a cost segregation.

So if you have made improvements to your property or if you purchased a recently rehabbed property, be sure to provide these break-outs to your tax advisors to accelerate your tax deduction.

Related: Real Estate Depreciation: A Strategy for Saving Money on Taxes?

4. Something Better than Depreciation?

Believe it or not there is actually something that is even better than depreciation and cost segregation, and that is a “repairs expense”.

Repairs are even better than depreciation because rather than writing off your money over 5, 7, or 27 years, you are able to write off 100% of the repairs cost in the year you incur that expense.  If you are looking at making some improvements to your rental property, here is where strategic planning can really help.

For example, rather than spending $30,000 to change out your entire roof and then having to depreciate that $30,000 over multiple years, why not consider repairing part of the roof over  time so that each repair cost can be deducted on the  year you spend the money?

A slight shift in how your repairs and improvements are done can mean writing off your costs today rather than in the future.

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About Author

Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As real estate investors herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.

20 Comments

  1. Hi Amanda,

    Well written. I have few cents to add here. I am not sure if its state to state based or federal, but my CPA (both of them) told me that if you make too much money you can’t file for depreciation yearly, so sometimes its over-hyped the power of depreciation/expenses on year to year basis. Now even though you can’t file for them yearly, you can still write off every expense and even depreciation when you sell your property. In other words according to IRS, for more money making people (which I am not ;), they put all expenses and depreciation in a bucket and you can use that bucket only when you sell your property. So if you sell your property with 50k profit and you showed IRS that expenses and depreciation have costed you 30k for that property, then you will pay capital earning tax only on (50-30)k = 20k. This is little tricky rule as in most of the hyped-up salespitches related to real estate investing, they tell you that you can write off all your expenses and depreciation etc, but they don’t tell you that it all depends upon your income to write them off, If you have less income you can write them every year but if you have high income (high according to IRS not me :)) you have to wait till you sell your property and then you can use those expenses and depreciation to save some money on capital earning tax. Just my few thoughts. Overall very informative article.

    Thanks for sharing

    • this statement is accurate and inaccurate at the same time and is often a confusion point for people. Essentially depreciation is just like any other expenses in that it can always be used to offset rental income (this is regardless of how much money a person makes). Therefore there is no different rule for depreciation for high income people. The potential limitation with respect to income is that for people who invest passively on the side and also make a lot of income, any excess losses from rentals may not be able to offset their W-2 income fully. Great comment nonetheless and maybe I can write an article about it in the coming week!

      • I think you got his inference, Amanda. I was thinking Anuj was getting bad advice when I first read the comment. After rereading it, I think he is referring to the PAL rules. That might be helpful for folks to know.

        Better for you to write it than me! :)

  2. Can you elaborate a little more on your last comment (about how to claim a roof replacement as a repair vs capital improvement)? I once had an investor tell me you could take all the costs associated with a roof job off your taxes in the year you do the work as long as you only do 1/2 of the work one year and the other half the next year – is that true??

  3. I want to install a second bathroom in my 3BR 1 BR investment property to raise the value to meet he areas current growing property values for 3/2 properties from a tax planning perspective it would be ideal to begin the improvements in late December and carry through to January of the following year? Or do the upgrades whenever I can and have the costs split across two years

    • Hi Lear:

      the new bathroom addition would most likely be an improvements regardless of whether you split it in two years or not as it would be hard to argue that you made “repairs” to a bathroom that did not exist. The repairs strategy is with respect to repairing an existing item that was broken in the property. (ie repairing a broken toilet or sink ,etc.)

  4. Can you clarify “repairing part of the roof over time” a little more? Are you suggesting we just do patch jobs as required, or only do one section of the roof after it shows signs of damage?

    Ex) replace shingles on west side of house in 2014 and east side in 2015?

    Just trying to get an applied idea of repairs vs improvement here.

    • Hi Mattt: Yes patch jobs and minor repairs are usually better from a tax perspective as they are deductible in the current year. If you just decided to replace the entire roof then it would be an improvement. As long as it makes sense from a cost perspective (the patch work), then tax wise that makes the most sense.

      • Great information. I’m trying to make sure I understand this topic. If for example you replace the roof over one unit of a duplex, then the following year you replace the other half, is that considered a repair? Sounds too good to be true!

  5. Great article Amanda, thanks. I do have a couple questions.

    Hypothetical, I have a rental property and have held it for 5 years. Never depreciated and now sell for a 50k profit. You mentioned that I may have to pay recapture taxes. How is it decided if I need to pay taxes or not? How much would I have to pay?

    Also, how is the percentage of land and building determined? One would need the building value to calculate the depreciation write off.

    Thanks,
    Thai

    • Hi Thai:

      Yes the IRS can potentially calculate recapture taxes even though no depreciation were taken. Since you have never done it before I would definitely suggest you speak with your CPA to determine the best way to present this on your tax returns so that you dont end up paying taxes on something not previously written off. With respect to land v building some good ways to split those out are property tax bills and also appraisal reports. For certain larger properties the cost segregation companies can use other methods to get more percentages into building.

  6. Or how about paying off one really good property that you have and leaving it to your kids in a will and never having to pay the taxes? They would get the stepped up basis right?

  7. Amanda,

    How does depreciation recpature tax work within a syndication where I am an investor? So if I get depreciation on my Schedule K-1, and this offsets the income generated, then when property is sold, am I subject to recapture tax in same way that I would be if I were to have bought the property directly?

    • You are correct, Craig.

      If you are getting a K-1, I assume you are in a partnership that owns the property. The easiest way to think about this is you own a pro-rata share of the property. You are just like a 100% owner; the only difference is the percentage. All of the benefits/costs of an owner are yours, just in a smaller percentage.

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