4 Depreciation Tax Mistakes Investors Need to Avoid

4 Depreciation Tax Mistakes Investors Need to Avoid

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Amanda Han

Amanda Han has been a CPA specializing in tax strategies for real estate, self-directed investing, and individual tax planning for over 18 years. She’s been investing in real estate herself for over 10 years with a focus on long-term hold residential and multifamily assets across multiple states.

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As both a tax strategist and real estate investor, Amanda combines her passion of real estate investing with her expertise in tax. Her goal is to help investors with strategies designed to supercharge their wealth-building using entity structuring, self-directed investing, and income offset opportunities to keep more of what they make.

Her highly rated book Tax Strategies for the Savvy Real Estate Investor is amongst Amazon’s bestseller list. Amanda is also a frequent contributor, speaker, and educator to some of the nation’s top investment and self-directed IRA companies.

Amanda and her husband Matt MacFarland have a passion for animals and founded Animals for Armed Forces, a non-profit organization that has helped to place over 1,800 shelter pets with forever homes.

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Her cutting-edge tax strategies have been featured in prominent publications, including Money Magazine, Realtor.com, and AllBusiness.com. Amanda was a speaker at “Talks at Google” that features influential thinkers and creators. Amanda has also appeared in CNBC’s Smart Money Talk Radio, as well as BiggerPockets podcasts.

She is a 40 under 40 honoree by CPA Practice Advisor, showcased amongst the best and brightest talent in the accounting profession. Her firm Keystone CPA, Inc. was awarded a two-time winner of the Top CPA of Orange County Award by OC Metro Magazine.

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She is certified by the CA State Board of Accountancy and is a member of the prestigious American Institute of Certified Public Accountants (AICPA) with clients across the nation.

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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.

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.