Depreciation Calculations-please help to figure it out

25 Replies

Hey guys,

I feel like Ive always struggled with depreciation concept...

So, Ive been googling it, and here is what I found:


Let’s say you buy a single-family home for $200,000. The tax assessor’s estimate of the land value
is $75,000, and the building value estimate is $125,000. Your
depreciation expense that you take each year against rental income would
be $125,000 divided by the IRS allowed 27.5 years of useful life (residential real estate)
for a depreciation expense each year of $4,545. So thanks to that
depreciation expense, you are saving (assuming you can use passive
activity losses) $4,545 multiplied by your marginal tax rate (which is a
topic for another day). This could be tax savings from $1,000 to $2,000
per year, just for the depreciation amount.
https://www.zillow.com/blog/ta...

So, do understand correctly, if I am in a 30% tax bracket, then that $4,545 I need to multiply by 0.3 (because of 30%) to calculate how much tax depreciation will save me? So:
$4,545  multiply by 0.3 =$1350 less I will pay in taxes? Correct?


Does it apply to my house as well? Or only rentals?

Depreciation is only on rentals.

You would not take the tax assessors $125k value and depreciate that. 

If assessor= $75k Land, and $125k building 

Then 62.5% of the value is building 

You apply 62.5% to your total cost of buying the property. So if you paid more your depreciation will be more, or if you paid less it would be less. You're just using the ratio from the assessor, not actual figures. 

I'm also not sure I'd directly apply the tax savings to depreciation. 

If you have high income on a property it may not have a loss, even after depreciation. Or the loss could be LESS than the depreciation amount, or you could show income. 


@Mary Jay , Natalie gave some great advice, plus looks like she's an accountant and knows this stuff forward and backward. I'll offer some insight from the layman's perspective.

Depreciation is the 9th wonder of the world, after the other 7 and compound interest. The IRS says your building is slowly wearing out, so just like they allow you take any other legit business expense and deduct that from your income, so too they have allowed REI's to gradually take the total expense of purchasing a piece of real estate and deduct that from our income. You've got the formula correct for residential. If you ever do commercial, it's 39 years, FYI.

You take your PURCHASE PRICE (not the tax assessor's appraisal or any one else's appraisal) and divvy that BASIS up between land and structure. The only time you'd use an appraiser to get the BASIS is if you inherited the property thru an estate as a bequest. A commonly used method is 80/20 (structure / land). As you noted, you only get to depreciate the structure, not the land. Land doesn't wear out, in the IRS's eyes. Then add any capitalized improvements to your basis, or you can also depreciate those separately. That can be to your advantage if the items have a shorter lifespan than 27.5 years, which most do. One example is a new HVAC system. I can't recall the IRS guidance, but I believe those only have a useful lifespan of 15 years, so you could depreciate that faster than the overall structure. Carpet has 7 years, hardwood floor maybe 20 years. Ask your CPA or research online for MACRs tables.

To offset taxes from other income, your income from the rental, minus all operating expenses, minus interest from debt serving (but not the principle!), minus depreciation must equal a negative number.  That negative number represents a paper loss and can be carried over to other properties and/or W-2 income.  Basically, your paper loss reduces your total income from all sources, assuming the income qualifies and you qualify.  As you noted, there are limitations and exclusions based on amount and type of income.  But yes, you have to take into account marginal tax rates, and depending on how much paper loss you have you could even move into a lower tax bracket.

Due to combination of real estate deprecation and tax credits, I have had several years where I had a NEGATIVE effective tax rate, meaning I got money from the Govt at tax filing time that I never paid in.  It truly was "free money" to me, graciously paid for by the taxpayers of the USA, courtesy of our wonky tax system.  These days, though, I'm on the opposite side, paying my "fair share".  However, my federal effective tax rate is typically below 3%.  Just fyi.  Depreciation is powerful stuff!

Side note: Here's why I call depreciation the 9th wonder of the world: 27.5 years from now, your building will be worth zero dollars in the eyes of the IRS. But you and I have been keeping our buildings in good repair, so they are actually worth much more. Also, they've allowed us to deduct all of the maintenance expenses to keep them in good repair, so we kind of get a "double dip". Not really, but it's just kind of funny how that works. Also, if you sell the building after it becomes worthless in the IRS's eyes to someone else, the BASIS resets to market value (i.e. what they paid for it). Magic!

Originally posted by @Erik Whiting:


@Mary Jay, Natalie gave some great advice, plus looks like she's an accountant and knows this stuff forward and backward.  I'll offer some insight from the layman's perspective.


Depreciation is the 9th wonder of the world, after the other 7 and compound interest. The IRS says your building is slowly wearing out, so just like they allow you take any other legit business expense and deduct that from your income, so too they have allowed REI's to gradually take the total expense of purchasing a piece of real estate and deduct that from our income. You've got the formula correct for residential. If you ever do commercial, it's 39 years, FYI.


You take your PURCHASE PRICE (not the tax assessor's appraisal or any one else's appraisal) and divvy that BASIS up between land and structure.  The only time you'd use an appraiser to get the BASIS is if you inherited the property thru an estate as a bequest.   A commonly used method is 80/20 (structure / land).   As you noted, you only get to depreciate the structure, not the land.  Land doesn't wear out, in the IRS's eyes.  Then add any capitalized improvements to your basis, or you can also depreciate those separately.  That can be to your advantage if the items have a shorter lifespan than 27.5 years, which most do.  One example is a new HVAC system.  I can't recall the IRS guidance, but I believe those only have a useful lifespan of 15 years, so you could depreciate that faster than the overall structure.  Carpet has 7 years, hardwood floor maybe 20 years.  Ask your CPA or research online for MACRs tables.


To offset taxes from other income, your income from the rental, minus all operating expenses, minus interest from debt serving (but not the principle!), minus depreciation must equal a negative number.  That negative number represents a paper loss and can be carried over to other properties and/or W-2 income.  Basically, your paper loss reduces your total income from all sources, assuming the income qualifies and you qualify.  As you noted, there are limitations and exclusions based on amount and type of income.  But yes, you have to take into account marginal tax rates, and depending on how much paper loss you have you could even move into a lower tax bracket.


Due to combination of real estate deprecation and tax credits, I have had several years where I had a NEGATIVE effective tax rate, meaning I got money from the Govt at tax filing time that I never paid in.  It truly was "free money" to me, graciously paid for by the taxpayers of the USA, courtesy of our wonky tax system.  These days, though, I'm on the opposite side, paying my "fair share".  However, my federal effective tax rate is typically below 3%.  Just fyi.  Depreciation is powerful stuff!


Side note: Here's why I call depreciation the 9th wonder of the world: 27.5 years from now, your building will be worth zero dollars in the eyes of the IRS.  But you and I have been keeping our buildings in good repair, so they are actually worth much more.  Also, they've allowed us to deduct all of the maintenance expenses to keep them in good repair, so we kind of get a "double dip". Not really, but it's just kind of funny how that works.  Also, if you sell the building after it becomes worthless in the IRS's eyes to someone else, the BASIS resets to market value (i.e. what they paid for it).  Magic!


 

If depreciation is the 9th wonder of the world, is depreciation recapture the seventh level of hell? lol

Just to add onto the conversation, that $0 value after 27.5 years means you pay capital gains taxes on the full selling price when you sell the property. (At least that's my understanding as a non-cpa)

Originally posted by @Natalie Kolodij :

Depreciation is only on rentals. 

You would not take the tax assessors $125k value and depreciate that. 

If assessor= $75k Land, and $125k building 

Then 62.5% of the value is building 

You apply 62.5% to your total cost of buying the property. So if you paid more your depreciation will be more, or if you paid less it would be less. You're just using the ratio from the assessor, not actual figures. 

I'm also not sure I'd directly apply the tax savings to depreciation. 

If you have high income on a property it may not have a loss, even after depreciation. Or the loss could be LESS than the depreciation amount, or you could show income. 

Thank you. Can we put it into numbers? Its easier for me to understand it then...

So lets say bought property for 200K and its worth 200K, 62 % is the value of the building, which is 125K...Then 125K divide by 27 years, right? So we get 4.6K, which is what I can depreciate per year, right?

Then, if I am in a 30% tax bracket, then lets say I make 100K per year, then my taxable income will be 100k minus that 4.6K=95.4K is my taxable income, right? Is that how depreciation lowers my taxable income?

 

Originally posted by @Erik W. :


@Mary Jay, Natalie gave some great advice, plus looks like she's an accountant and knows this stuff forward and backward.  I'll offer some insight from the layman's perspective.

Depreciation is the 9th wonder of the world, after the other 7 and compound interest. The IRS says your building is slowly wearing out, so just like they allow you take any other legit business expense and deduct that from your income, so too they have allowed REI's to gradually take the total expense of purchasing a piece of real estate and deduct that from our income. You've got the formula correct for residential. If you ever do commercial, it's 39 years, FYI.

You take your PURCHASE PRICE (not the tax assessor's appraisal or any one else's appraisal) and divvy that BASIS up between land and structure.  The only time you'd use an appraiser to get the BASIS is if you inherited the property thru an estate as a bequest.   A commonly used method is 80/20 (structure / land).   As you noted, you only get to depreciate the structure, not the land.  Land doesn't wear out, in the IRS's eyes.  Then add any capitalized improvements to your basis, or you can also depreciate those separately.  That can be to your advantage if the items have a shorter lifespan than 27.5 years, which most do.  One example is a new HVAC system.  I can't recall the IRS guidance, but I believe those only have a useful lifespan of 15 years, so you could depreciate that faster than the overall structure.  Carpet has 7 years, hardwood floor maybe 20 years.  Ask your CPA or research online for MACRs tables.

To offset taxes from other income, your income from the rental, minus all operating expenses, minus interest from debt serving (but not the principle!), minus depreciation must equal a negative number.  That negative number represents a paper loss and can be carried over to other properties and/or W-2 income.  Basically, your paper loss reduces your total income from all sources, assuming the income qualifies and you qualify.  As you noted, there are limitations and exclusions based on amount and type of income.  But yes, you have to take into account marginal tax rates, and depending on how much paper loss you have you could even move into a lower tax bracket.

Due to combination of real estate deprecation and tax credits, I have had several years where I had a NEGATIVE effective tax rate, meaning I got money from the Govt at tax filing time that I never paid in.  It truly was "free money" to me, graciously paid for by the taxpayers of the USA, courtesy of our wonky tax system.  These days, though, I'm on the opposite side, paying my "fair share".  However, my federal effective tax rate is typically below 3%.  Just fyi.  Depreciation is powerful stuff!

Side note: Here's why I call depreciation the 9th wonder of the world: 27.5 years from now, your building will be worth zero dollars in the eyes of the IRS.  But you and I have been keeping our buildings in good repair, so they are actually worth much more.  Also, they've allowed us to deduct all of the maintenance expenses to keep them in good repair, so we kind of get a "double dip". Not really, but it's just kind of funny how that works.  Also, if you sell the building after it becomes worthless in the IRS's eyes to someone else, the BASIS resets to market value (i.e. what they paid for it).  Magic!

 Thank you!

Can you please give me an example? I understand better if I have numbers.... Lets say property bought for 200K, worth 200K, income from W2 is 100K... How to calculate how much less taxes will I pay due to depreciation? 

@Mary Jay , I'm just a humble REI, I can't even calculate how much less tax I pay, because my income from year to year is variable, my tax rate is therefore also variable.

An oversimplified example: let's say your income is $100,000 ($70K from W-2 + $30K from rent) and your tax bracket is 25%.  For the sake of this example, we will ignore the standard / itemized deductions and marginal tax rates.

Property A purchased for $275,000 brings in $30K rent as mentioned above.  Operating Expenses are $12K.  Debt Service Interest is $9K.  Depreciation is $275,000 / 27.5 = $10K per year.  Calculate your P/L (profit or loss) thus: $30K - $12K - $9K - $10K = negative $1K.

If your$100K income all came from W-2 wages with no deductions/deprecation, you would have paid 25% of $100,000 or $25,000 in taxes.  BUT!  The IRS considers the $30K of rent income to actually be a $1,000 loss because your combined expenses, interest and deprecation exceeded the rent income.  Therefore, your taxable income is your W-2 wages ($70K) minus your $1K paper loss....so you only pay 25% taxes on $69,000.  

Here's the fun part: you actually had a net income of $78K. Depreciation is a paper loss, meaning that the property is still probably worth at least as much, if not more, than $275K. That $10K you took for depreciation didn't take one penny out of your pocket or net worth. The loss only shows up on your tax papers, not your wallet. The $9K of net cash rent left over after subtracting expenses and interest is still jingling around in your pocket.

Rent: $30K - expenses ($12K) - interest ($9K) = $9K of net income that you pay no taxes on.  

In addition, the $1K paper loss shields $1K of your W-2 income so you pay no taxes on it either.  If you were still in the 25% tax bracket, the paper loss saves you $250 of W-2 wage tax.

This is stupidly simple example of how it works, and I used made up numbers that probably have no validity in the real world.  For example, debt interest of $9K on a $275K property is probably way too low: I'd expect triple that much unless you had a huge down payment.  We also didn't consider standard or itemized deductions except for the rental property, nor did we consider the marginal tax rate which would reduce the tax % at lower levels of income.  I have no calculator to figure that out precisely.  Talk to a CPA who can show you a real example.  Just remember, depreciation is a loss on paper, not in reality.  But the current tax law allows you to use some or all of that loss to reduce taxable income from the rental itself and any extra can be applied to other sources in many situations, including other rentals that produce a net profit even after depreciation.

Welcome to the 9th Wonder of the World: depreciation!

Originally posted by @Erik W. :


@Mary Jay , Natalie gave some great advice, plus looks like she's an accountant and knows this stuff forward and backward. I'll offer some insight from the layman's perspective.

Depreciation is the 9th wonder of the world, after the other 7 and compound interest. The IRS says your building is slowly wearing out, so just like they allow you take any other legit business expense and deduct that from your income, so too they have allowed REI's to gradually take the total expense of purchasing a piece of real estate and deduct that from our income. You've got the formula correct for residential. If you ever do commercial, it's 39 years, FYI.

You take your PURCHASE PRICE (not the tax assessor's appraisal or any one else's appraisal) and divvy that BASIS up between land and structure. The only time you'd use an appraiser to get the BASIS is if you inherited the property thru an estate as a bequest. A commonly used method is 80/20 (structure / land). As you noted, you only get to depreciate the structure, not the land. Land doesn't wear out, in the IRS's eyes. Then add any capitalized improvements to your basis, or you can also depreciate those separately. That can be to your advantage if the items have a shorter lifespan than 27.5 years, which most do. One example is a new HVAC system. I can't recall the IRS guidance, but I believe those only have a useful lifespan of 15 years, so you could depreciate that faster than the overall structure. Carpet has 7 years, hardwood floor maybe 20 years. Ask your CPA or research online for MACRs tables.

To offset taxes from other income, your income from the rental, minus all operating expenses, minus interest from debt serving (but not the principle!), minus depreciation must equal a negative number.  That negative number represents a paper loss and can be carried over to other properties and/or W-2 income.  Basically, your paper loss reduces your total income from all sources, assuming the income qualifies and you qualify.  As you noted, there are limitations and exclusions based on amount and type of income.  But yes, you have to take into account marginal tax rates, and depending on how much paper loss you have you could even move into a lower tax bracket.

Due to combination of real estate deprecation and tax credits, I have had several years where I had a NEGATIVE effective tax rate, meaning I got money from the Govt at tax filing time that I never paid in.  It truly was "free money" to me, graciously paid for by the taxpayers of the USA, courtesy of our wonky tax system.  These days, though, I'm on the opposite side, paying my "fair share".  However, my federal effective tax rate is typically below 3%.  Just fyi.  Depreciation is powerful stuff!

Side note: Here's why I call depreciation the 9th wonder of the world: 27.5 years from now, your building will be worth zero dollars in the eyes of the IRS. But you and I have been keeping our buildings in good repair, so they are actually worth much more. Also, they've allowed us to deduct all of the maintenance expenses to keep them in good repair, so we kind of get a "double dip". Not really, but it's just kind of funny how that works. Also, if you sell the building after it becomes worthless in the IRS's eyes to someone else, the BASIS resets to market value (i.e. what they paid for it). Magic!

 Some of this is unfortuantely wrong which is why we try to keep replys simple on here. 

Using 80/20 is 100% not an allowable method - you'll take raked over the coals in audit. 

Appraisals can and should be looked at for the values, this IS an allowbale method by the IRS for determining your depreciable basis. 

On residential propeties HVAC is ABSOLTUELY part of the structure and can't be taken on a shorter life span, it's 27.5. You can only separate out non-structural non-permanent elements of a residential rental. 

Hardwoods are also 27.5, Carpet is 5 as it's considered not attached, appliances, window treatments, some counter tops, landscaping. 

But again- this is why she should talk to a tax pro to set this all up because information gets skewed easily online . 

Originally posted by @Mary Jay :
Originally posted by @Natalie Kolodij:

Depreciation is only on rentals. 

You would not take the tax assessors $125k value and depreciate that. 

If assessor= $75k Land, and $125k building 

Then 62.5% of the value is building 

You apply 62.5% to your total cost of buying the property. So if you paid more your depreciation will be more, or if you paid less it would be less. You're just using the ratio from the assessor, not actual figures. 

I'm also not sure I'd directly apply the tax savings to depreciation. 

If you have high income on a property it may not have a loss, even after depreciation. Or the loss could be LESS than the depreciation amount, or you could show income. 

Thank you. Can we put it into numbers? Its easier for me to understand it then...

So lets say bought property for 200K and its worth 200K, 62 % is the value of the building, which is 125K...Then 125K divide by 27 years, right? So we get 4.6K, which is what I can depreciate per year, right?

Then, if I am in a 30% tax bracket, then lets say I make 100K per year, then my taxable income will be 100k minus that 4.6K=95.4K is my taxable income, right? Is that how depreciation lowers my taxable income?

The depreciation calculation is correct. 

BUT what I'm saying is whta if you make $20k in rents, other expenses are 10k, and then after you deduct 4.6k depreciation you may still HAVE income- not a loss. 

Depreciation doesn't direclty guarantee you tax savings. Ideally, and often, it's what allows you to show a loss- but not always.n

 

Originally posted by @Natalie Kolodij :
Originally posted by @Erik Whiting:


@Mary Jay, Natalie gave some great advice, plus looks like she's an accountant and knows this stuff forward and backward.  I'll offer some insight from the layman's perspective.

Depreciation is the 9th wonder of the world, after the other 7 and compound interest. The IRS says your building is slowly wearing out, so just like they allow you take any other legit business expense and deduct that from your income, so too they have allowed REI's to gradually take the total expense of purchasing a piece of real estate and deduct that from our income. You've got the formula correct for residential. If you ever do commercial, it's 39 years, FYI.

You take your PURCHASE PRICE (not the tax assessor's appraisal or any one else's appraisal) and divvy that BASIS up between land and structure.  The only time you'd use an appraiser to get the BASIS is if you inherited the property thru an estate as a bequest.   A commonly used method is 80/20 (structure / land).   As you noted, you only get to depreciate the structure, not the land.  Land doesn't wear out, in the IRS's eyes.  Then add any capitalized improvements to your basis, or you can also depreciate those separately.  That can be to your advantage if the items have a shorter lifespan than 27.5 years, which most do.  One example is a new HVAC system.  I can't recall the IRS guidance, but I believe those only have a useful lifespan of 15 years, so you could depreciate that faster than the overall structure.  Carpet has 7 years, hardwood floor maybe 20 years.  Ask your CPA or research online for MACRs tables.

To offset taxes from other income, your income from the rental, minus all operating expenses, minus interest from debt serving (but not the principle!), minus depreciation must equal a negative number.  That negative number represents a paper loss and can be carried over to other properties and/or W-2 income.  Basically, your paper loss reduces your total income from all sources, assuming the income qualifies and you qualify.  As you noted, there are limitations and exclusions based on amount and type of income.  But yes, you have to take into account marginal tax rates, and depending on how much paper loss you have you could even move into a lower tax bracket.

Due to combination of real estate deprecation and tax credits, I have had several years where I had a NEGATIVE effective tax rate, meaning I got money from the Govt at tax filing time that I never paid in.  It truly was "free money" to me, graciously paid for by the taxpayers of the USA, courtesy of our wonky tax system.  These days, though, I'm on the opposite side, paying my "fair share".  However, my federal effective tax rate is typically below 3%.  Just fyi.  Depreciation is powerful stuff!

Side note: Here's why I call depreciation the 9th wonder of the world: 27.5 years from now, your building will be worth zero dollars in the eyes of the IRS.  But you and I have been keeping our buildings in good repair, so they are actually worth much more.  Also, they've allowed us to deduct all of the maintenance expenses to keep them in good repair, so we kind of get a "double dip". Not really, but it's just kind of funny how that works.  Also, if you sell the building after it becomes worthless in the IRS's eyes to someone else, the BASIS resets to market value (i.e. what they paid for it).  Magic!

 Some of this is unfortuantely wrong which is why we try to keep replys simple on here. 

Using 80/20 is 100% not an allowable method - you'll take raked over the coals in audit. 

Appraisals can and should be looked at for the values, this IS an allowbale method by the IRS for determining your depreciable basis. 

On residential propeties HVAC is ABSOLTUELY part of the structure and can't be taken on a shorter life span, it's 27.5. You can only separate out non-structural non-permanent elements of a residential rental. 

Hardwoods are also 27.5, Carpet is 5 as it's considered not attached, appliances, window treatments, some counter tops, landscaping. 

But again- this is why she should talk to a tax pro to set this all up because information gets skewed easily online . 


Can I ask you guys another question? About interest rate... 

interest rate is deductible...Lets say I paid 5K in interest , then
100K ( my salary) minus 5 K of interest, =95K of taxable income...

So, if I understand it correctly, then 30% taxes will be taken from 95K, not 100K. Correct?

So if there was no interest rate deduction, then I would of paid 30 K in taxes ( 100K times 0.3=30K in taxes)

But because of interest rate deductions  I will pay 28.5K in taxes? (95K times 0.3=28.5k)

Is that correct?



 

Originally posted by @Erik W. :

@Mary Jay, I'm just a humble REI, I can't even calculate how much less tax I pay, because my income from year to year is variable, my tax rate is therefore also variable.

An oversimplified example: let's say your income is $100,000 ($70K from W-2 + $30K from rent) and your tax bracket is 25%.  For the sake of this example, we will ignore the standard / itemized deductions and marginal tax rates.

Property A purchased for $275,000 brings in $30K rent as mentioned above.  Operating Expenses are $12K.  Debt Service Interest is $9K.  Depreciation is $275,000 / 27.5 = $10K per year.  Calculate your P/L (profit or loss) thus: $30K - $12K - $9K - $10K = negative $1K.

If your$100K income all came from W-2 wages with no deductions/deprecation, you would have paid 25% of $100,000 or $25,000 in taxes.  BUT!  The IRS considers the $30K of rent income to actually be a $1,000 loss because your combined expenses, interest and deprecation exceeded the rent income.  Therefore, your taxable income is your W-2 wages ($70K) minus your $1K paper loss....so you only pay 25% taxes on $69,000.  

Here's the fun part: you actually had a net income of $78K.  Depreciation is a paper loss, meaning that the property is still probably worth at least as much, if not more, than $275K.  That $10K you took for depreciation didn't take one penny out of your pocket or net worth.  The loss only shows up on your tax papers, not your wallet.  The $9K of net cash rent left over after subtracting expenses and interest is still jingling around in your pocket.

Rent: $30K - expenses ($12K) - interest ($9K) = $9K of net income that you pay no taxes on.  

In addition, the $1K paper loss shields $1K of your W-2 income so you pay no taxes on it either.  If you were still in the 25% tax bracket, the paper loss saves you $250 of W-2 wage tax.

This is stupidly simple example of how it works, and I used made up numbers that probably have no validity in the real world.  For example, debt interest of $9K on a $275K property is probably way too low: I'd expect triple that much unless you had a huge down payment.  We also didn't consider standard or itemized deductions except for the rental property, nor did we consider the marginal tax rate which would reduce the tax % at lower levels of income.  I have no calculator to figure that out precisely.  Talk to a CPA who can show you a real example.  Just remember, depreciation is a loss on paper, not in reality.  But the current tax law allows you to use some or all of that loss to reduce taxable income from the rental itself and any extra can be applied to other sources in many situations, including other rentals that produce a net profit even after depreciation.

Welcome to the 9th Wonder of the World: depreciation!

thank you!

How do you understand interest rate deduction?

 

Updated 9 months ago

just realized that in your example you already spoke about mortgage interest...and called it Debt Service Interest is $9K.

@Natalie Kolodij

Just to piggy back onto the conversation, the IRS allows us to depreciate our rental properties.  In the event we sell the property that depreciation that we took advantage of during the years we owned it must be paid back against your basis. Improvements made are also calculated against the depreciation to lessen the depreciation tax burden when you sell.  Is that true?  Of course when you pass away the depreciation you took advantage of goes away (no tax burden) and starts again with the new rental owner or heirs if they choose to take advantage of it. Appreciate your comments without you having to take us down that rabbit hole.




Originally posted by @Kenneth Garrett :

@Natalie Kolodij

Just to piggy back onto the conversation, the IRS allows us to depreciate our rental properties.  In the event we sell the property that depreciation that we took advantage of during the years we owned it must be paid back against your basis. Improvements made are also calculated against the depreciation to lessen the depreciation tax burden when you sell.  Is that true?  Of course when you pass away the depreciation you took advantage of goes away (no tax burden) and starts again with the new rental owner or heirs if they choose to take advantage of it. Appreciate your comments without you having to take us down that rabbit hole.

So depreciation reduces your adjusted basis. 

If you start with a building worth $100k and annual depreciation is $3,636

After ten years your adjusted basis would be $63,636 

NOW

If in year 5 you had done a $15k renovation

At year 5 your adjusted basis would be $100k- ($3,636 *5= 18.181) + 15,000 renovations = 96,819 

BUT

That renovation is now also going to be depreciated 

So year 6 adjusted basis would be $100k - (3,636*6=21,816) - 545 (15,0000/27.5) 

So basically yes renovations add basis- but then they're also depreciated. 

IF you do renovations TO SELL. Then they are just added to basis. 

When you calculate your gain the total portion that was caused by deduction depreciation over the years is taxed at your ordinary income tax rate. 

 

@Mary Jay , chiming back in with a clarification on the 80/20 rule for structure & land.  I should have clarified that this is a commonly used rule in MY town, where land is relatively cheap compared to the price of the structure.  For example, a little $40K house I bought recently had two vacant, identically sized residential single family house lots on the same street listed for sale at $5,000 and $6,500.  Doing the math we see that the land under my little house should be approximately 12.5%-16.25% of the total purchase.  If I wanted to be super aggressive, I could allocate more than 80% of the purchase price to the structure.  I save a copy of the listings in a folder so if the IRS ever decides to audit me, I will have documentation to show that my allocation percentage was reasonable.  Too, the 80/20 rule is what my CPA recommends.  He's the Pro, so I go with his advice especially when it seems well supported by our local market.

Yes, an appraisal can be used, but to clarify that too I would not rely on a County Assessor's appraisal.  In my area, those are off, sometimes by a considerable amount.  If you were to take out a loan, then perhaps the appraiser who run the numbers for the bank would be a good resource.

@Natalie Kolodij gave some great advice, and I recommend checking with a competent local professional for anything to do with taxes/legal issues.  Anything posted on BP should be taken with a grain of salt and/or general advice to give you ideas so you can start investigating on your own.  Real estate values, customs, and "rules" are almost always local.

Originally posted by @Erik W. :

@Mary Jay , chiming back in with a clarification on the 80/20 rule for structure & land.  I should have clarified that this is a commonly used rule in MY town, where land is relatively cheap compared to the price of the structure.  For example, a little $40K house I bought recently had two vacant, identically sized residential single family house lots on the same street listed for sale at $5,000 and $6,500.  Doing the math we see that the land under my little house should be approximately 12.5%-16.25% of the total purchase.  If I wanted to be super aggressive, I could allocate more than 80% of the purchase price to the structure.  I save a copy of the listings in a folder so if the IRS ever decides to audit me, I will have documentation to show that my allocation percentage was reasonable.  Too, the 80/20 rule is what my CPA recommends.  He's the Pro, so I go with his advice especially when it seems well supported by our local market.

Yes, an appraisal can be used, but to clarify that too I would not rely on a County Assessor's appraisal.  In my area, those are off, sometimes by a considerable amount.  If you were to take out a loan, then perhaps the appraiser who run the numbers for the bank would be a good resource.

@Natalie Kolodij gave some great advice, and I recommend checking with a competent local professional for anything to do with taxes/legal issues.  Anything posted on BP should be taken with a grain of salt and/or general advice to give you ideas so you can start investigating on your own.  Real estate values, customs, and "rules" are almost always local.

Again

Using 80/20 will NEVER hold in audit. 

The IRS allows 7 different allocation methods - this isn't one. 

This is lazy accounting. 

We're not saying to use the actual assessor amounts- but their split between land and building. And that is a recommended way by the IRS- regardless of where you live. 

If you have an appraisal and they allocate an actual amount to impovemnets or land- using that is actually the best method according to the IRS. 

Being local doesn't matter. Following the law and guidelines does. These "Rules" Aren't local- they are for your federal taxes. 

 

@Natalie Kolodij , so you're saying even if I have documented evidence (listings, comps) showing that the value of the land is LESS THAN 20% of the purchase price, the IRS will reject it automatically?  Could you please provide a citation of that so I can show it to my CPA?

Originally posted by @Erik W. :

@Natalie Kolodij, so you're saying even if I have documented evidence (listings, comps) showing that the value of the land is LESS THAN 20% of the purchase price, the IRS will reject it automatically?  Could you please provide a citation of that so I can show it to my CPA?

 Just saying oh 80/20....is not an allowable any thing . 

If your CPA did that they suck, they don't know the law, and they're doing a lazy "we've always done it this way". 

I'm saying there are 7 allowable IRS ways for determining depreciate allocations. 

Top 3:

Building assessor land v. allocation % 

Appraisal values 

Land comps 

The IRS states that you have to use a reasonable method- and these have been determined by years of audits, letter rulings, and tax court cases on the matter. 

Originally posted by @Erik W. :

@Natalie Kolodij, so you're saying even if I have documented evidence (listings, comps) showing that the value of the land is LESS THAN 20% of the purchase price, the IRS will reject it automatically?  Could you please provide a citation of that so I can show it to my CPA?

 If you have adequate Comps showing land values then you could use THOSE VALUES. 

That's allowable and reasonable. 

Having accurate values for land worth and then just using a preset % instead doesn't make any sense. You HAVE something more reliable. 


@Mary Jay

Your depreciation calculations in your original post were absolutely correct for the scenario you described.

Depreciation reduces your taxable rental income. If you have $4545 in depreciation, then you avoid the income tax on $4545 of rental income.  

If you have a net passive loss and are able to take the full amount of the net passive loss allowance, then the reduction in your total tax liability is your marginal tax bracket rate times the amount of your net passive loss from the rental activity.  This amount could be greater then your actual depreciation expense, but since your question only addressed the tax savings due to depreciation alone, your assessment of the tax outcome was correct in your original post.

Originally posted by @Natalie Kolodij :
Originally posted by @Erik Whiting:

@Natalie Kolodij, so you're saying even if I have documented evidence (listings, comps) showing that the value of the land is LESS THAN 20% of the purchase price, the IRS will reject it automatically?  Could you please provide a citation of that so I can show it to my CPA?

 Just saying oh 80/20....is not an allowable any thing . 


look, I just might be some stoned guy sitting on his couch watching Joe Rogan podcasts, but I do understand that there are properties in this country that fall under 80/20 , it’s just a simple fact of reality, areas with this ratio exist , and are probably quite common where Land is plenty full.

Originally posted by @Natalie Kolodij :
Originally posted by @Erik Whiting:

@Natalie Kolodij, so you're saying even if I have documented evidence (listings, comps) showing that the value of the land is LESS THAN 20% of the purchase price, the IRS will reject it automatically?  Could you please provide a citation of that so I can show it to my CPA?

 If you have adequate Comps showing land values then you could use THOSE VALUES. 

That's allowable and reasonable. 

but for some strange reason, in the post right before this you made, you stated that it is never allowable.

in the next breath you define it as “allowable and reasonable“


 

Originally posted by @Steve Legnaioli :
Originally posted by @Natalie Kolodij:
Originally posted by @Erik Whiting:

@Natalie Kolodij, so you're saying even if I have documented evidence (listings, comps) showing that the value of the land is LESS THAN 20% of the purchase price, the IRS will reject it automatically?  Could you please provide a citation of that so I can show it to my CPA?

 If you have adequate Comps showing land values then you could use THOSE VALUES. 

That's allowable and reasonable. 

but for some strange reason, in the post right before this you made, you stated that it is never allowable.

in the next breath you define it as “allowable and reasonable“

This is clearly a sign of somebody who does not know what they are talking about

Is that what it's a sign of? 


The argument was my CPA uses 80/20 can he, and can he even if I show land is LESS than 20 

The answer is no that still doesn't allow a straight up 80/20 split

You need to use actual amounts.

But I appreciate your making such rash assumptions based on 1 out of my 3k posts on here. Clearly a sign of someone who is here to learn and be a valuable forum member. 

 

Originally posted by @Erik W. :

@Mary Jay , chiming back in with a clarification on the 80/20 rule for structure & land.  I should have clarified that this is a commonly used rule in MY town, where land is relatively cheap compared to the price of the structure.  For example, a little $40K house I bought recently had two vacant, identically sized residential single family house lots on the same street listed for sale at $5,000 and $6,500.  Doing the math we see that the land under my little house should be approximately 12.5%-16.25% of the total purchase.  If I wanted to be super aggressive, I could allocate more than 80% of the purchase price to the structure.  I save a copy of the listings in a folder so if the IRS ever decides to audit me, I will have documentation to show that my allocation percentage was reasonable.  Too, the 80/20 rule is what my CPA recommends.  He's the Pro, so I go with his advice especially when it seems well supported by our local market.

Yes, an appraisal can be used, but to clarify that too I would not rely on a County Assessor's appraisal.  In my area, those are off, sometimes by a considerable amount.  If you were to take out a loan, then perhaps the appraiser who run the numbers for the bank would be a good resource.

@Natalie Kolodij gave some great advice, and I recommend checking with a competent local professional for anything to do with taxes/legal issues.  Anything posted on BP should be taken with a grain of salt and/or general advice to give you ideas so you can start investigating on your own.  Real estate values, customs, and "rules" are almost always local.

There is no 80/20 RULE. That is made up bs used by lazy people. Occasionally where we are absent a physical land value using an estimate of other property works; however, you must have a reasonable method.