How Can I Take Advantage of Depreciation?

Tax, SDIRAs & Cost Segregation
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How Can I Take Advantage of Depreciation?

Harry Campbell
Los Angeles, CA · Member since 2010 · 40 posts · 1 vote

So I rented out my condo last July and I'm starting to look over my tax documents in preparation for filing. I've done a lot of research over the past couple days but to my understanding since I make less than 100k AGI, I can deduct up to 25k in passive losses from my W2 income.

That almost sounds too good to be true though since I'll be close to 75k AGI this year putting me in a marginal tax bracket of 25% fed, 9% state, plus fica/med, etc. I understand I'll have to pay back 25% in depreciation recapture when I sell but still 15 cents on the dollar plus all that time of tax deferral sounds pretty awesome - how did I not know about this haha?

I charge my tenant 1900/mo for rent and my expenses are as following: 550/mo for interest, 300/mo for prop taxes/insurance and 400/mo for HOA. I know the basic formula for calculating depreciation, but I haven't looked into it too much yet. I bought the place for 280k, put in about 10k worth of repairs and redfin tells me the land value is 180k(which seems absurdly high). So depreciation would be 290-180 = 110k. 110k/27.5/12 = 333/mo in depreciation.

So that's 1583/mo in expenses/depreciation which obviously wouldn't create a passive loss since my rent is 1900/mo but I spent $3,500 last year on a new A/C and dishwasher. So I had my place rented for 6 months and made $1902($317*6 months) but after the $3,500 in expenses I lost $1,600 on the property.

In my scenario, wouldn't it make sense to get my depreciation as high as possible since this is a phantom expense. My property will still be cash flowing every month but if I can increase my depreciation/month and get as close to 25k in passive losses I'm guaranteeing myself 15 cents on the dollar plus tax deferral.

Another idea I had: I don't want actual expenses but wouldn't it make sense to do a lot of repairs/fixes while I have the place rented out. For example, if I wanted to put in new floors, new carpet, etc wouldn't these all count as expenses and I would get basically a 40% discount off these expenses(until I hit the 25k limit) since it would be reducing my taxes at my marginal rate.

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Dave Toelkes
Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
12y
Originally posted by @Harry Campbell:

That's what one of my friends told me to do actually. My county tax assessment lists the same value that's on Redfin. I bought this place as a short sale in 2009 so I know it's gone up 20-30% or more since then. How would I find the land/building value of a nearby comp though? The are some comps in the 350k range that I would like to use and would also be appropriate.

Here is how you use the tax assessor value. You have to look at the entire assessment -- land and improvements. Take the assessed value of the improvements, divided by the total of land and improvements, then multiply by your purchase price. The result is the initial depreciation basis for your property.

For example, you say you purchased for $280K and the tax assessor value of your land is $110K. If the tax assessor's value of the improvements is $330K, then your initial depreciation basis will be 330/440 x 280 = 210K. If you subtract 210K from your purchase price, then you paid 70K for the land. In this example, your cost basis for the land is $70K and can not be depreciated.

Your purchase price, for depreciation purposes, is allocated $70K to land and $210K to depreciable improvements. Now, you say that you also put another $10K into additional improvements. This is added to the depreciation basis for the dwelling structure, giving you a tax basis of $220K for the dwelling structure (in this example) which you can depreciate over the next 27.5 years. As you make additional capital improvements over time, the cost of each improvement is depreciated on a separate 27.5 year schedule.

In this example, $8000 of net income from your rental will be sheltered by depreciation each full year your property is in service as a rental. If the property cash flows, you may never sell it, and then you will never have to pay taxes on the unrecaptured depreciation. Isn't depreciation great?

To extend this example further, you say you have about $650 per month in net cash flow after you pay the recurring costs each month. That amount is sheltered by your depreciation.

What you have not considered yet, are all the other costs of ownership that take money out of your pocket. You will have advertising costs, legal fees, repairs, maintenance/upkeep. n If your landlord tenant law requires you to pay interest on security deposits, then that may come out of pocket. In one state where I have rental property, there is a rental license that I have to purchase each year. Property management fees may also be in your budget if you don't self-manage. Since your depreciation expense has already been used up to cover your expected net cash flow, these costs will create a tax loss for this property. HOA dues, property taxes, and insurance premiums do go up and those cost increases will add to your paper loss. There may be a time when your property is vacant and there is no rent coming in. The excess depreciation that you did not use to offset income also adds to your tax loss. It is not hard to envision a day when you might have $10K or more in tax losses (in spite of your $8K depreciation expense) to use against the $25K passive activity loss allowance.

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  • Brie SchmidtBusiness Member
    Moderator
    Real Estate Broker · Chicago, IL · Member since 2013 · 6k+ posts · 5k+ votes
    12y

    I am not tax expert - but we were told to look at the assessed land value with the county and use that for depreciation basis. I would not use redfin

    The A/C and dishwasher can only be counted if they were installed after the property became a rental and both those items would be depreciated over time - not a single year.

    With that rent vs expenses you are likely to report a profit every year so you do want an accurate cost basis to start to minimize the taxes you will pay. Your cost basis does not change over time so get it as close as possible.

    As for your last comment, yes in theory. You also need to look at the depreciation schedule - not all items are depreciated at the same time (some 1 year, some 5, some 10)

    If you plan on doing your own taxes I suggest reading

    http://www.amazon.com/Every-Landlord%C2%92s-Tax-Deduction-Guide/dp/1413319270/ref=sr_1_1?ie=UTF8&qid=1391796046&sr=8-1&keywords=Every+Landlord%27s+Tax+Deduction+Guide

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  • Brie SchmidtBusiness Member
    Moderator
    Real Estate Broker · Chicago, IL · Member since 2013 · 6k+ posts · 5k+ votes
    12y

    @Harry Campbell

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  • Jessica S.
    Real Estate Agent · Portland, OR · Member since 2013 · 154 posts · 67 votes
    12y

    The new ac and dishwasher you put in need to be depreciated not deducted as expenses. Same goes for the other upgrades you're thinking of doing. Repairs are considered expenses and can be deducted, but none of what you mentioned falls into that category, unfortunately.

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  • Harry Campbell
    OP
    Los Angeles, CA · Member since 2010 · 40 posts · 1 vote
    12y

    Haha ok that makes sense, I spent the past two days figuring out the whole passive loss side of it. Looks like I need to spend some time now looking into to how to calculate depreciation for my property and my repairs/upgrades. And yes, the dishwasher and A/C were put in while the unit was rented out.

    Guess I can't complain too much since I'm making money on the property but it would be nice to figure out a way to take advantage of that 25k passive loss exclusion before I start making too much money :)

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  • Andrew S.
    Investor · Raleigh, NC · Member since 2013 · 1k+ posts · 708 votes
    12y

    I definitely agree with @Brie Schmidt

    - don't use redfin for determining land value. County tax assessment is one way, but my understanding is that any reasonable way you come up with in determining the land and building value is acceptable. For example, you could use a nearby comp, if a plot of land happened to sell recently, or you could use the replacement value your insurance company put on your home insurance, etc.

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  • Brie SchmidtBusiness Member
    Moderator
    Real Estate Broker · Chicago, IL · Member since 2013 · 6k+ posts · 5k+ votes
    12y

    The book I listed is a great resource. I reread it every year

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  • Andrew S.
    Investor · Raleigh, NC · Member since 2013 · 1k+ posts · 708 votes
    12y

    I agree - that's a must-have and actually, as far as tax-related information it's not an overly tedious read, even cover-to-cover.

    Plus, it's now available in e-Book format as well

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  • Steve Babiak
    Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
    12y
    Originally posted by @Harry Campbell:
    ... And yes, the dishwasher and A/C were put in while the unit was rented out.
    ...

    When the dishwasher and AC were put in is irrelevant when dealing with rental property; they are depreciated. Maybe @Steven Hamilton II will have some more to say.

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  • Brie SchmidtBusiness Member
    Moderator
    Real Estate Broker · Chicago, IL · Member since 2013 · 6k+ posts · 5k+ votes
    12y

    @Steve Babiak - he just converted the unit from personal residence to a rental this year so anything done before the conversion can not be depreciated.

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  • Harry Campbell
    OP
    Los Angeles, CA · Member since 2010 · 40 posts · 1 vote
    12y

    Thanks for the replies guys. I think I'm going to pick up that book and get to reading. I kind of like this stuff so it's fun for me to figure it all out :)

    0Reply
  • Harry Campbell
    OP
    Los Angeles, CA · Member since 2010 · 40 posts · 1 vote
    12y
    Originally posted by @Andrew S.:
    I definitely agree with @Brie Schmidt

    - don't use redfin for determining land value. County tax assessment is one way, but my understanding is that any reasonable way you come up with in determining the land and building value is acceptable. For example, you could use a nearby comp, if a plot of land happened to sell recently, or you could use the replacement value your insurance company put on your home insurance, etc.

    That's what one of my friends told me to do actually. My county tax assessment lists the same value that's on Redfin. I bought this place as a short sale in 2009 so I know it's gone up 20-30% or more since then. How would I find the land/building value of a nearby comp though? The are some comps in the 350k range that I would like to use and would also be appropriate.

    0Reply
  • Dave Toelkes
    Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
    12y
    Originally posted by @Harry Campbell:

    That's what one of my friends told me to do actually. My county tax assessment lists the same value that's on Redfin. I bought this place as a short sale in 2009 so I know it's gone up 20-30% or more since then. How would I find the land/building value of a nearby comp though? The are some comps in the 350k range that I would like to use and would also be appropriate.

    Here is how you use the tax assessor value. You have to look at the entire assessment -- land and improvements. Take the assessed value of the improvements, divided by the total of land and improvements, then multiply by your purchase price. The result is the initial depreciation basis for your property.

    For example, you say you purchased for $280K and the tax assessor value of your land is $110K. If the tax assessor's value of the improvements is $330K, then your initial depreciation basis will be 330/440 x 280 = 210K. If you subtract 210K from your purchase price, then you paid 70K for the land. In this example, your cost basis for the land is $70K and can not be depreciated.

    Your purchase price, for depreciation purposes, is allocated $70K to land and $210K to depreciable improvements. Now, you say that you also put another $10K into additional improvements. This is added to the depreciation basis for the dwelling structure, giving you a tax basis of $220K for the dwelling structure (in this example) which you can depreciate over the next 27.5 years. As you make additional capital improvements over time, the cost of each improvement is depreciated on a separate 27.5 year schedule.

    In this example, $8000 of net income from your rental will be sheltered by depreciation each full year your property is in service as a rental. If the property cash flows, you may never sell it, and then you will never have to pay taxes on the unrecaptured depreciation. Isn't depreciation great?

    To extend this example further, you say you have about $650 per month in net cash flow after you pay the recurring costs each month. That amount is sheltered by your depreciation.

    What you have not considered yet, are all the other costs of ownership that take money out of your pocket. You will have advertising costs, legal fees, repairs, maintenance/upkeep. n If your landlord tenant law requires you to pay interest on security deposits, then that may come out of pocket. In one state where I have rental property, there is a rental license that I have to purchase each year. Property management fees may also be in your budget if you don't self-manage. Since your depreciation expense has already been used up to cover your expected net cash flow, these costs will create a tax loss for this property. HOA dues, property taxes, and insurance premiums do go up and those cost increases will add to your paper loss. There may be a time when your property is vacant and there is no rent coming in. The excess depreciation that you did not use to offset income also adds to your tax loss. It is not hard to envision a day when you might have $10K or more in tax losses (in spite of your $8K depreciation expense) to use against the $25K passive activity loss allowance.

    2Reply
  • Steve Babiak
    Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
    12y
    Originally posted by @Brie Schmidt:
    @Steve Babiak - he just converted the unit from personal residence to a rental this year so anything done before the conversion can not be depreciated.

    That certainly is INCORRECT! The improvements made while he owned it and lived in it contribute to the cost basis of the property (purchase plus improvements), and you depreciate the structure value (cost basis minus land value) over 27.5 years.

    2Reply
  • Brie SchmidtBusiness Member
    Moderator
    Real Estate Broker · Chicago, IL · Member since 2013 · 6k+ posts · 5k+ votes
    12y

    @Steve Babiak - yes, we were talking about him depreciating them as an improvement - not part of the cost basis. a 5 or 10 year depreciation is much different that a 27.5 year

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  • Steve Babiak
    Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
    12y
    Originally posted by @Brie Schmidt:
    ...

    The A/C and dishwasher can only be counted if they were installed after the property became a rental and both those items would be depreciated over time - not a single year.

    ....

    As for your last comment, yes in theory. You also need to look at the depreciation schedule - not all items are depreciated at the same time (some 1 year, some 5, some 10)

    ...

    I was going based on the first piece in this quote, which is incorrect without a doubt. Only improvements after it is made a rental will come into play with the second piece in the quote, and if a cost segregation is performed it's conceivable that the depreciation could fall into a shorter time than 27.5 years.

    0Reply
  • Cassandra Olivier
    Investor · Oklahoma City, OK · Member since 2014 · 13 posts · 2 votes
    12y

    Awesome book!

    0Reply
  • Harry Campbell
    OP
    Los Angeles, CA · Member since 2010 · 40 posts · 1 vote
    12y
    Originally posted by @Dave Toelkes:
    Originally posted by @Harry Campbell:

    That's what one of my friends told me to do actually. My county tax assessment lists the same value that's on Redfin. I bought this place as a short sale in 2009 so I know it's gone up 20-30% or more since then. How would I find the land/building value of a nearby comp though? The are some comps in the 350k range that I would like to use and would also be appropriate.

    Here is how you use the tax assessor value. You have to look at the entire assessment -- land and improvements. Take the assessed value of the improvements, divided by the total of land and improvements, then multiply by your purchase price. The result is the initial depreciation basis for your property.

    For example, you say you purchased for $280K and the tax assessor value of your land is $110K. If the tax assessor's value of the improvements is $330K, then your initial depreciation basis will be 330/440 x 280 = 210K. If you subtract 210K from your purchase price, then you paid 70K for the land. In this example, your cost basis for the land is $70K and can not be depreciated.

    Your purchase price, for depreciation purposes, is allocated $70K to land and $210K to depreciable improvements. Now, you say that you also put another $10K into additional improvements. This is added to the depreciation basis for the dwelling structure, giving you a tax basis of $220K for the dwelling structure (in this example) which you can depreciate over the next 27.5 years. As you make additional capital improvements over time, the cost of each improvement is depreciated on a separate 27.5 year schedule.

    In this example, $8000 of net income from your rental will be sheltered by depreciation each full year your property is in service as a rental. If the property cash flows, you may never sell it, and then you will never have to pay taxes on the unrecaptured depreciation. Isn't depreciation great?

    To extend this example further, you say you have about $650 per month in net cash flow after you pay the recurring costs each month. That amount is sheltered by your depreciation.

    What you have not considered yet, are all the other costs of ownership that take money out of your pocket. You will have advertising costs, legal fees, repairs, maintenance/upkeep. n If your landlord tenant law requires you to pay interest on security deposits, then that may come out of pocket. In one state where I have rental property, there is a rental license that I have to purchase each year. Property management fees may also be in your budget if you don't self-manage. Since your depreciation expense has already been used up to cover your expected net cash flow, these costs will create a tax loss for this property. HOA dues, property taxes, and insurance premiums do go up and those cost increases will add to your paper loss. There may be a time when your property is vacant and there is no rent coming in. The excess depreciation that you did not use to offset income also adds to your tax loss. It is not hard to envision a day when you might have $10K or more in tax losses (in spite of your $8K depreciation expense) to use against the $25K passive activity loss allowance.


    Dave, thanks for the detailed reply, took me a few days to digest it :) I wish the numbers you used in your example were for my property but you flipped the land/improvements value. My land is worth 180l, improvements are only worth 100k. Here are the numbers for my property:

    Purchase price: 280,000

    From my property tax bill, land value =181,355

    From my property tax bill, improvements = 100,753.

    So (100,753/{181,355+100,753}) * 280,000 = 100,000 (initial depreciation basis).

    I did 10k worth of upgrades(new counters, appliances, etc) so I add that to the 100k to get 110,000 as my tax basis for the dwelling structure.

    Now if all that math looks right, here's my question. Why is my land value 180k and dwelling only 100k? That just doesn't seem right to me, shouldn't those amounts be skewed the other way?

    110/27.5 = 4k a year in depreciation, that won't do much for me. How do I/can I use comps to raise the value of my structure like someone else mentioned? I bought my place as a short sale in 2009 so it's definitely gone up 20-40% since depending on what comps you use. From other posts I've read, seems like land is usually 20% of value but in my case it's closer to 65%.

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  • Dave Toelkes
    Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
    12y
    Originally posted by @Harry Campbell:

    How do I/can I use comps to raise the value of my structure like someone else mentioned? I bought my place as a short sale in 2009 so it's definitely gone up 20-40% since depending on what comps you use. From other posts I've read, seems like land is usually 20% of value but in my case it's closer to 65%.

    Harry,

    Unfortunately, comps won't help you at all here since comps normally don't separate land/improvements. If you are willing to pay for an appraisal, the appraiser will )if you ask) give you an appraised value for the property and segregate the value of the land from the improvements. Then you can use the appraisal the same way I suggested you use the tax assessor numbers.

    Don't be surprised if the appraiser looks at the high cost of vacant land to arrive at the same (or nearly the same) ratio of land/improvements that your assessor used.

    Even if you use the numbers you have, 110K in depreciation over the course of the next 27.5 years is sheltering 110K in net rental income from your income taxes. The lower depreciation than my example, might give you a net taxable rental income and you won't be able to use the net passive loss allowance. This is not a bad thing. Just means that it will be easier for you to borrow money to fund your next rental acquisition.

    The benefit of rental property investing is not the tax benefits, it is the cash flow your tenants are buying for you. Rejoice when you get to the point when you are paying $1 million in income taxes, because that means you are really hauling in the cash. I will gladly pay income taxes on two or three million of net rental income because that would mean that my tenants are buying up to 100 million of property for me and after my tenants have paid off the loans, I will own all that free and clear.

    1Reply
  • Andy Collins
    SFR Investor · Dallas, TX · Member since 2011 · 604 posts · 243 votes
    12y

    don't confuse your "cost basis" with the value of the property,,in simple terms, what you paid for the structure, plus improvements, are your cost basis,,I don't think its 'market value' plays any part in the cost basis.

    I'm not a CPA or accountant, but own rentals (and have a very good CPA) and we have never changed the cost basis because the value went up

    0Reply
  • Harry Campbell
    OP
    Los Angeles, CA · Member since 2010 · 40 posts · 1 vote
    12y
    Originally posted by @Andy Collins:
    don't confuse your "cost basis" with the value of the property,,in simple terms, what you paid for the structure, plus improvements, are your cost basis,,I don't think its 'market value' plays any part in the cost basis.

    I'm not a CPA or accountant, but own rentals (and have a very good CPA) and we have never changed the cost basis because the value went up

    Ah ok gotcha, so cost basis does not include the value of the land. What is cost basis used for then other than depreciation calculation?

    0Reply
  • Harry Campbell
    OP
    Los Angeles, CA · Member since 2010 · 40 posts · 1 vote
    12y
    Originally posted by @Dave Toelkes:
    Originally posted by @Harry Campbell:

    How do I/can I use comps to raise the value of my structure like someone else mentioned? I bought my place as a short sale in 2009 so it's definitely gone up 20-40% since depending on what comps you use. From other posts I've read, seems like land is usually 20% of value but in my case it's closer to 65%.

    Harry,

    Unfortunately, comps won't help you at all here since comps normally don't separate land/improvements. If you are willing to pay for an appraisal, the appraiser will )if you ask) give you an appraised value for the property and segregate the value of the land from the improvements. Then you can use the appraisal the same way I suggested you use the tax assessor numbers.

    Don't be surprised if the appraiser looks at the high cost of vacant land to arrive at the same (or nearly the same) ratio of land/improvements that your assessor used.

    Even if you use the numbers you have, 110K in depreciation over the course of the next 27.5 years is sheltering 110K in net rental income from your income taxes. The lower depreciation than my example, might give you a net taxable rental income and you won't be able to use the net passive loss allowance. This is not a bad thing. Just means that it will be easier for you to borrow money to fund your next rental acquisition.

    The benefit of rental property investing is not the tax benefits, it is the cash flow your tenants are buying for you. Rejoice when you get to the point when you are paying $1 million in income taxes, because that means you are really hauling in the cash. I will gladly pay income taxes on two or three million of net rental income because that would mean that my tenants are buying up to 100 million of property for me and after my tenants have paid off the loans, I will own all that free and clear.

    Hi Dave,

    I completely agree with you that it's a good problem to have :) but with depreciation, that's a phantom expense. My marginal tax bracket will be around 40%(fed+state+fica/med) last/this year with an AGI below 100k. I should be doing everything I can to increase depreciation and get as close to a 25k passive loss(assuming most of the loss is depreciation). I pay back depreciation in X number of years at 25% so that's a guaranteed 15 cent on the dollar return plus all that time of tax deferral(a value worth it in itself).

    It just seems to me that depreciation calculation is so arbitrary. I have not seen one solid reference/source as to how to calculate it - everyone has a different answer. I'll probably consult with a CPA on this one but don't see why I shouldn't be very aggressive here. Thanks again for the tips, you've been extremely helpful!

    0Reply
  • Dave Toelkes
    Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
    12y

    @Harry Campbell

    If you want a definiitive source on how to calculate depreciation, you don't need to look any further than the IRS. There is an IRS Pub that gives you the how to. Check out IRS Pub 946. However, I am guessing that you aren't really bemoaning the lack of definitive guidance on how to calculate depreciation, but rather, the lack of guidance on how to properly determine the tax basis of the property to be depreciated.

    The IRS is fairly quiet on this point. Their guidance is that whatever is reasonable AND defensible is acceptable. The tax assessor ratio times purchase price is the most often cited technique for determining what portion of your cost basis can be recovered through depreciation. Your cost basis includes the value of the land, but since land cannot be depreciated, your depreciation basis is the cost of the dwelling structure. (Note that I am saying "cost" not value).

    So, there really is no definitive answer to your question. If you go to the tax rolls and see that the majority of improved properties in your neighborhood have the land assessed at 25% of the total property assessment valuation, then you should be safe in using a 75% ratio in calculating the depreciation basis for your dwelling structure. Just keep all your notes and calculations in case you are asked to defend your valuation.

    1Reply
  • Harry Campbell
    OP
    Los Angeles, CA · Member since 2010 · 40 posts · 1 vote
    12y

    Just as an FYI to anyone who is wondering. NOLO's Landlord Tax Deduction book was awesome! I used the chapter on calculating depreciation to come up with my own land/bldg value. I found a free calculator online at http://www.building-cost.net/ that based it's estimates off the National Building Cost Manual by Craftsman Book Company(recommended in NOLO too).

    I ended up with $213k building value and 67k land value which was a lot better than the 70k/210k my tax documents showed. If I get contacted by the IRS about this number I'll at least have something to show them how I arrived at this figure. I think it's smart to be aggressive on the depreciation number since according to NOLO: the penalty may be imposed only if you overstated the value of your depreciable property by at least 200% over the correct amount and the overstatement resulted in an underpayment of tax of at least $5,000.

    So basically there is a lot of wiggle room and the IRS knows that.

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