Depreciation - What the heck??!

22 Replies

A few questions...........

To what extend does depreciation really affect a person's taxes/capital gains on a property when it is sold?

Does it benefit or harm a person to claim LITTLE TO NO depreciation each year on a property?

Does it benefit or harm a person to claim MORE TO MOST depreciation each year on a property?

It would really be helpful if someone well versed or educated in the matter could expand on how reporting depreciation really affects the property when it comes time to sell, and capital gains and other deductions against the basis are calculated.  Anyone offering a clear understanding of how it works, and what the best course of action for reporting depreciation would be appreciated!

There's really no choice when it comes to taking depreciation on real estate.  The IRS has set guidelines for the amount of depreciation to take based on the property type, its use and a couple of other things.

When it comes time to sell, your capital gains and depreciation recapture (for a rental property) are calculated based on the amount of Depreciation Allowed or ALLOWABLE.  

This means that even if you didn't take depreciation or you took something less than what you were entitled to take, you still pay taxes for the Depreciation Recapture at the amount that you should have taken.

So you just calculate the proper amount and take it.  There's no strategy to employ on this.

Now if you're talking about accelerated depreciation methods for equipment, that's a completely different answer and whether or not to accelerate or not is dependent on a whole host of factors.

@Cara Lonsdale I am not a CPA but I do speak with mine and with our (BP) own @Brandon Hall and I can tell you that you want to take all the depreciation you are allowed to take. In the end when you sell the IRS doesn't care if you took it or not they will still view it as you did and act accordingly regarding the recapture. Is that correct Brandon?

This is what I've seen others inquire about.

@Cara Lonsdale

First, depreciation is a loan. You get to take a deduction now, and it lowers your taxes now. When you sell - you "repay" the loan, meaning that you pay more capital gain tax at sale. The technical term is "depreciation recapture" - you can google my blog post about it.

Second, as @Linda Weygant pointed out, you must take at least  some depreciation, it's not optional.

Where you do have some room to play is how much depreciation is taken. There're various techniques to increase or decrease it, to a degree. Like with a loan - the more you take, the more you have to return. So, if you increase depreciation now - you might get more savings today. The flip side is that you will get higher taxes when you sell.

Whether or not it makes sense to increase current depreciation (what you called "benefit or harm") - depends on a lot of factors, and it can only be decided case-by-case. The rule of thumb says - go for it, but it's not reliable, as we all have different thumbs.

Thanks @Linda Weygant   That is helpful.  So, Let's set aside accelerated depreciation for a minute as to stay clear.

So, it sounds like taking as much as I can is the way to go, since it will be assumed to have been taken anyway.  So, how do I come up with the amount to depreciate?  Am I depreciating the land?  The building?  The appliances?  The HVAC?  How drilled down do I go to depreciate the max while staying in the "allowed" column?

Originally posted by @Cara Lonsdale :

Thanks @Linda Weygant  That is helpful.  So, Let's set aside accelerated depreciation for a minute as to stay clear.

So, it sounds like taking as much as I can is the way to go, since it will be assumed to have been taken anyway.  So, how do I come up with the amount to depreciate?  Am I depreciating the land?  The building?  The appliances?  The HVAC?  How drilled down do I go to depreciate the max while staying in the "allowed" column?

 Land is never depreciable.

What you are depreciating is your Basis in the Building.  Basis is generally calculated by factoring in the costs of acquisition plus any costs of improvement.

You can frequently carve out the value of the appliances and other Equipment that either comes with or is added to the building and whether or not to do so really depends on your overall financial situation.  Equipment is generally considered to be items that are not permanently attached to the building and have value on their own.  So, for example, an iron railing would not be Equipment, but an appliance package would be.  Water heaters and HVAC systems can be considered Equipment as well.

Also, in the event you are purchasing a home with Equipment in place, the value of any Equipment (also called Personal Property) generally has to be carved out and disclosed at closing (here in Colorado - other states may vary) in order to then be able to carve that portion out from the purchase price.

You can get a Segregation Study or Segregation Analysis done on your property to maximize the depreciation expense.  These experts will carve out and evaluate any and everything that could be considered equipment.  Generally, the cost for this study does not pay for itself until or unless you have a multi-unit building.  Common thought is that a single family home is rarely going to have enough equipment in it to justify the expense of the study.

Originally posted by @Linda Weygant :
Originally posted by @Cara Lonsdale:

You can get a Segregation Study or Segregation Analysis done on your property to maximize the depreciation expense.  These experts will carve out and evaluate any and everything that could be considered equipment.  Generally, the cost for this study does not pay for itself until or unless you have a multi-unit building.  Common thought is that a single family home is rarely going to have enough equipment in it to justify the expense of the study.

A Cost segregation study/analysis, is a quantifiable savings, most firms will provide an upfront estimate to see whether it's worth it or not. That being said, I tend to agree with Linda, that you are not going to see a tremendous amount of benefit on any property worth under $500,000. However the new 100% bonus depreciation law could change that!

Don't forget besides "equipment" there are many aspects of 'tangible or personal property' that can be accelerate their deprecation over a 5-year period. And Land improvements, landscaping, pavement, fencing, etc. can be depreciated over a 15-year period

Originally posted by @Linda Weygant :
Originally posted by @Cara Lonsdale:

Thanks @Linda Weygant  That is helpful.  So, Let's set aside accelerated depreciation for a minute as to stay clear.

So, it sounds like taking as much as I can is the way to go, since it will be assumed to have been taken anyway.  So, how do I come up with the amount to depreciate?  Am I depreciating the land?  The building?  The appliances?  The HVAC?  How drilled down do I go to depreciate the max while staying in the "allowed" column?

 Land is never depreciable.

What you are depreciating is your Basis in the Building.  Basis is generally calculated by factoring in the costs of acquisition plus any costs of improvement.

You can frequently carve out the value of the appliances and other Equipment that either comes with or is added to the building and whether or not to do so really depends on your overall financial situation.  Equipment is generally considered to be items that are not permanently attached to the building and have value on their own.  So, for example, an iron railing would not be Equipment, but an appliance package would be.  Water heaters and HVAC systems can be considered Equipment as well.

Also, in the event you are purchasing a home with Equipment in place, the value of any Equipment (also called Personal Property) generally has to be carved out and disclosed at closing (here in Colorado - other states may vary) in order to then be able to carve that portion out from the purchase price.

You can get a Segregation Study or Segregation Analysis done on your property to maximize the depreciation expense.  These experts will carve out and evaluate any and everything that could be considered equipment.  Generally, the cost for this study does not pay for itself until or unless you have a multi-unit building.  Common thought is that a single family home is rarely going to have enough equipment in it to justify the expense of the study.

 I know of these Segregation Studies, and have watched a really good webinar on it, but that's when I was dealing with a syndcation deal for a commercial property.  I have never really drilled down on it for a rental property, and the cost would not even make it worth doing at that point.

This is very interesting.  I guess my biggest misconception was that I thought that if I didn't take as much, I wouldn't have as much recapture when I sold.  UG.  So, I was wrong.  They will take it back regardless of whether I claimed it or not.  So I have to start claiming all I can.

Thank you Linda!

Originally posted by @Cara Lonsdale :

 I know of these Segregation Studies, and have watched a really good webinar on it, but that's when I was dealing with a syndcation deal for a commercial property.  I have never really drilled down on it for a rental property, and the cost would not even make it worth doing at that point.

This is very interesting.  I guess my biggest misconception was that I thought that if I didn't take as much, I wouldn't have as much recapture when I sold.  UG.  So, I was wrong.  They will take it back regardless of whether I claimed it or not.  So I have to start claiming all I can.

Thank you Linda!

If you've been claiming depreciation incorrectly for several years, you have a couple of choices.

If it's been less than 3 years, you can amend your tax returns to claim the additional depreciation and you'll still get whatever benefits you may or may not have coming to you based on the lowering of your income.

or

You can work through and file form 3115 which would allow you to declare this as a change in accounting procedure/method, correct several years worth of that change all at once and then move forward with the new procedure/method.  

Depreciation and taxes are one/two of the least sexy and most misunderstood topics in real estate.  Good dialogue above.  Larger assets, combined with cost segregation, later combined with a refinance (or a 1031) materially improves the after-tax return on investment.

@Cara Lonsdale , this is the extension of where you were going and what @Mike Dymski alluded to.  The 1031 exchange defers both gain and depreciation recapture.  So in essence it is a way to have your cake and eat it to (although I've been pondering all day why I would want to have cake and not eat it...).  You get the tax benefit of depreciation but do not have to pay back the loan as @Michael Plaks said.

Your gain is the the adjusted cost basis subtracted from the net sales price.  the adjusted cost basis is the purchase price + any improvements - depreciation.  So if you bought a property for 100K and put 20K of improvements and then held it for a period of time so that you had taken $50K of depreciation your adjusted cost basis is $70K.  If you sell for 200K your gain is $130K of which 50K is depreciation recapture (higher tax %) and 80K is capital gain.  That can be substantially more tax than folks think.  The 1031 defers it all.

Originally posted by @Cara Lonsdale :

Thanks @Linda Weygant   That is helpful.  So, Let's set aside accelerated depreciation for a minute as to stay clear.

So, it sounds like taking as much as I can is the way to go, since it will be assumed to have been taken anyway.  So, how do I come up with the amount to depreciate?  Am I depreciating the land?  The building?  The appliances?  The HVAC?  How drilled down do I go to depreciate the max while staying in the "allowed" column?

 Based on the questions you're asking, you need to consult with a CPA before you do your taxes.  You don't want to mess that up.

@Dave Foster great explanation of how it all works. 

I am thinking way down the road here in my case but am wondering;

1) If two property owners were both ready to do an exchange, is it feasible for them to 'switch properties' assuming the number could work out in a mutually beneficial way?

2)IF that is a possibility, could the same person/s who held properties in different LLCs have those separate entities exchange with each other. 

The first scenario seems logical, the second would seem to good to be true ;-)

Thanks, Dan Dietz

@Daniel Dietz , And you're absolutely right.  The first works and was actually the only way 1031s happened for decades - people traded properties.  Imagine the kinds of daisy chains we had to deal with - I want your duplex but you don't want my SF.  You want the other guys commercial property.  But he doesn't want your duplex he wants my SF.  so he swaps with me and then I swap with you.  Crazy stuff and much easier now.  

The second scenario is possible but fraught with peril as well.  Identical ownership creates a related party issue.   Similar ownership can come into question as well.  If you have unrelated entities then yes they could swap properties with no gain recognized as long as valuations worked out.  But in essence you're trading with yourself so at the end of the day you're still owning everything you did before.  In a 1031 the depreciation clock does not restart.  l

Originally posted by @Daniel Dietz :

@Dave Foster great explanation of how it all works. 

I am thinking way down the road here in my case but am wondering;

1) If two property owners were both ready to do an exchange, is it feasible for them to 'switch properties' assuming the number could work out in a mutually beneficial way?

2)IF that is a possibility, could the same person/s who held properties in different LLCs have those separate entities exchange with each other. 

The first scenario seems logical, the second would seem to good to be true ;-)

Thanks, Dan Dietz

Daniel, I've heard stories of (friendly) owners doing #1 every 5-7 years, new cost seg, and reset depreciation.

Another interesting point with depreciation recapture is that the rate is 25%.  However, when you take depreciation, it could have reduced the highest bracket of income (ie. 39.6%).  

Originally posted by @Linda Weygant :

There's really no choice when it comes to taking depreciation on real estate.  The IRS has set guidelines for the amount of depreciation to take based on the property type, its use and a couple of other things.

When it comes time to sell, your capital gains and depreciation recapture (for a rental property) are calculated based on the amount of Depreciation Allowed or ALLOWABLE.  

This means that even if you didn't take depreciation or you took something less than what you were entitled to take, you still pay taxes for the Depreciation Recapture at the amount that you should have taken.

So you just calculate the proper amount and take it.  There's no strategy to employ on this.

Now if you're talking about accelerated depreciation methods for equipment, that's a completely different answer and whether or not to accelerate or not is dependent on a whole host of factors.

I'm going to disagree with Linda just slightly on these points...and it's nitpicking but having 25 years experience in Tax, I've seen a few things...and you need to hire a CPA to discuss them to determine if they are right for you....

The IRS has advised that you can elect to not depreciate anything under $2,500.  That's pretty generous.  Just because you have the option NOT to depreciate anything under that amount, doesn't mean that you CAN'T depreciate anything under that amount.  If you want to depreciate that $900 washer and $900 dryer, then you can instead of expensing it.  The key is consistency...the IRS likes consistency.

Your depreciation and "basis" in that depreciable asset could get a bit complicated depending on how you acquired the house, where it's located in relation to your home, and what condition it was in when you bought it.  Two examples:

a) If you acquired the house via "Tax Lien", you presumably paid legal fees to an attorney to foreclose on the lien and go through the court process.  Say you paid $3,500 in legal fees.  That $3,500 in legal fees is not an "expense" that you can deduct on your taxes - those fees are considered part of your "basis" in the property and generally speaking, are pro-rated between the value of the land and the value of the house (say land is worth 20% of the value and the house is worth 80%, then you prorate your basis accordingly).  As Linda pointed out, Land is not depreciable, so the the 80% portion is depreciated over the applicable life of the house.

b)  Say you buy a foreclosure that needs a ton of work.  You have general repairs you make to the house and it's about two hours away from your home so you can are allowed to deduct your mileage in that it isn't "commuting miles".  Your repairs are considered "construction work in process" until the house is rented.  The mileage you incur driving back and forth to that house is included in the basis of your "construction work in process"....so when you depreciate your asset - call it "Remodel" you must depreciate those miles and include it as a cost of the "Remodel" asset.

Your depreciation recapture and impact at sale will depend on the asset type, and how much depreciation you've taken.  This also will affect your year to year taxable income.  Generally, a person uses the "MACRS" depreciation method on assets which depreciates assets quicker up front.  You can elect to use a slower method of depreciation in order to defer the depreciation expense further over time.  This is an old school tax planning method I've seen used MANY times and it's something you need to talk to your CPA about before you elect to do it.

The final thought is we don't know how you hold your property and the information discussed above could be different depending if you are taxed as an individual or single member LLC (that has up to $25,000 in allowable deductions to revenue based on Schedule E rules), or you are flipping on Schedule C, or you are an S-Corp, or a Partnership.

The best is answer is you should consult with a CPA, learn the options, and do what's best for you and your business.

@Cara Lonsdale

It was suggested above that you have two options to fix incorrect past depreciation: a simple amending and a very complicated Form 3115. 

That is only partially correct. You are NOT allowed to amend past returns to correct depreciation. Form 3115 is the only clean way to do it, but it's absolutely not a DIY project.

@Ed E.

@Mike Dymski

@Dave Foster (I love your music by the way.  Tee Hee,  I bet you've never heard THAT before).

Thank you for your contributions.  Very helpful, and illuminating!  

Cara this is where many people who start in real estate then decide they want to sell their rentals and if their rentals are in a non appreciating market.. the investor can end up selling for what they paid for the property lose money on the sales commission then have to pay tax on the recapture... so once folks start loading up on rentals they need to understand if they buy in historic non depreciating markets exit is tough.. and you are in the for long haul  IE give the properties to your kids or heirs at step up basis.

this happens to us who buy airplanes big time.. you go to sell it and like a used car a used airplane will drop in value about 30 to 50% then hold for many many years.. so when you buy new and take that great accelerated depreciation you need to recapture it and its a huge hit.. ergo you trade up and buy a JET thats why there are so many private jets.. 

I know I am retiring from my rental portfolio and have been selling off over the last 3 years and recapture sure takes a lot of the fun out of owning these things... and then what happens if your max leverage in a non appreciating market you don't really have the cash even if you sell to 1031 without coming up with a good amount of cash to keep from having boot.. 

this is why i like Notes so well.. and land.. so going forward my portfolio is all development land and notes.

@Cara Lonsdale , If only I could remember where my royalty checks were :)

Great question and great discussion!

Just to clarify, refinancing the property resets the clock and starts depreciation all over? 

Originally posted by @Nathan G. :

Great question and great discussion!

Just to clarify, refinancing the property resets the clock and starts depreciation all over? 

Not an expert here.. but no refi does not you just get refi proceeds TAX DEFFERRED your basis stays were it was and continues to lower as you continue to depreciate over time.. same with 1031 you are just moving your basis to another property with the idea of scaling.. up..  Me thinks when you die your heirs can step up basis and start over. and then their are charitable remainder trusts that clients of mine have used for tax strategies..   but i could be all wrong as well.

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