Originally posted by
@Jim Kennedy:
@Steve Rozenberg - Oh man is this right in my wheelhouse. Get ready to learn the good, the bad, and the ugly about depreciation as it pertains to your question. I am a CPA who has done work for hundreds of real estate investors over the past 13 years, and I own and rent a series of residential and commercial units here in sunny, scenic South Jersey and (until recently) in Texas. Ready? Here we go:
So folks have already covered many of the depreciation basics. Here's a great rule of thumb.
- Figure: $3,000 of annual depreciation for the first $100,000 of purchase price and
- $3,600 for every $100,000 thereafter.
The difference in #1 and #2 is because when you bought your house, you also (usually) bought some land, which cannot be depreciated because land is good forever, so there's an allocation factor to exclude a standard amount for the land.
Example: $150K purchase provides $4800 annual depreciation . That's $400/month. So you can have taxable income of up to $400 every month and pay no tax.
Folks have explained correctly that you take your depreciable basis over 27.5 years; 1/27.5th each year (3.64%). The reason is because of an IRC concept called the matching concept, in which you match expenses to the period in which they occur. For example, when you pay the July water bill, you deduct it in the current year, because it happened that year. (Although the IRC says it in a much more confusing way: "You derived substantially all the economic benefit during the current period") And when you paid the first quarter R/E taxes, you write that off in the current year. And the tenant ad you ran, and so on. However, the economic life of the house will last you more than one year (hopefully) and hence that 27.5 year rule.
After that you can jack up the depreciation by doing cost segregation. We do that for our clients, when we break the house up into shorter depreciation lives, mostly 5 or 15 years. This is an aggressive method, so it needs to be properly documents. We use a list of 64 things that can be depreciated over 5 years, each one substantiated by a court case, a Revenue Ruling or a Private Letter Ruling. Same thing for 15 year property. Front loading the depreciation accelerates your write-offs, because who knows if you're gonna hold your property all 27 years?
Effective tax planning features taking advantages of write-offs in the year possible, and cost seg is a great way to do it.
Now its not all riches. The depreciation lowers your cost basis, so there will be more gain when you sell it but so what? Its not an even Steven trade off. I mean you're taking depreciation annually, and its saving you tax at some incremental rate - 25%, 28%, 31%, etc but when you sell it and have a big gain, that gain is taxed at long term capital gains rates, which for most folks is only 15%! Yes you pay some tax on the recapture of the depreciation at 25% as some folks will be quick to point out, but the savings that you got annually while renting it still exceed the tax you pay at the sale.
Be careful though. There is a nasty rule in the IRC (Internal Revenue Code) that says you must recapture all the depreciation that was allowed, or WOULD HAVE been allowed. I have come across more than one client who said "I don't want to depreciate the property, so I can keep a high basis and less gain on the sale". I am forced to tell them, "Sorry, but nice try". Then again, there's a little loophole in that case whereby I can make a cumulative adjustment this year for all the depreciation not taken previously, but that's another post this long for another day. Just know there are often solutions in the tax code, if you know where to look.
If you made it this far and are still awake, then if you have any more questions, let me know.
Jim Kennedy, CPA
