All Forum Posts by: Paul Caputo

@Aaron Smith that's a tricky one. I'm guessing the property was already rented by the previous tenant and you gave her the last month free to move out so you could start renovating. So it would've technically been in service from closing since it was already rented at that point. If it was still "rentable" (could be rented whether or not it actually is) after that it's still in service, if it's not rentable then it'd be out of service until it is again rentable. You definitely need to talk to your CPA to figure this one out. If I get some time I'll lookup if there's any guidance in the IRS publications on this matter. Any thoughts on that @Natalie Kolodij?

Depreciation starts when the asset is "placed in service" which for a rental property is when it's ready to be rented. Sounds like you're not there yet so there wouldn't be any depreciation yet. 

Thanks for the mention @Michael Plaks! A few things I'd like to add here. Whether something qualifies as 5 year personal property or a long life asset that is either a structural component or necessary for the general operation and maintenance of the building relies on the "facts and circumstances" of the particular asset. There are 6 "tests" known as the WhiteCo factors that are used to determine if an asset is personal property or structural/necessary to the building. So for everything that could qualify it can really go either way depending on the circumstances. That's why its so important to have a qualified construction engineer who also knows the tax code looking at assets to classify them properly as @Yonah Weiss pointed out.

@Patrick Liska There isn't a real "list" of what qualifies and what doesn't because in different situations the same asset could go either way. With your school to apartment conversion I'd recommend getting out in front of it and getting preliminary cost seg consulting to maximize 5 year assets and be able to expense out all the retired assets. We get the best results when we can say "do this, don't do that" before you start the conversion or construction.

On the cabinets most of the time they'll qualify as personal property in the kitchen, but not in the bathroom. This isn't necessarily because of the Morrison case it's because bathrooms are considered necessary for the operation of a building since they provide "human comfort". Even though you can easily remove a toilet and will surely have to replace it before it's 27.5 or 39 year life expires that doesn't matter because it has to be there. 

The Amerisouth case is a great example of what NOT to do with cost seg. Many assets incorrectly classified and even assets they didn't own put on the depreciation schedule on top of Amerisouth stopping correspondence to the Tax Court. This is a pretty obvious case of trying to bend the rules to your favor which is a big no no. 

As with everything with the IRS make sure you can back it up!

@Logan Allec I agree on a single $220K property it's probably not worth it, but it all depends on the specific situation. We've done everything from under $100K rental houses (usually multiple properties at once) up to billion dollar aerospace and energy facilities and cost seg has been beneficial every time. Of course the benefits are higher with bigger properties, but smaller properties can still have thousands in tax savings. 

And @Yonah Weiss is right the new 100% bonus depreciation is gonna make cost seg much more beneficial moving forward.

So just like everything in real estate it all depends on your personal situation.

@Nathan Amato If you want to get the depreciation nailed down properly you can have a cost segregation study done on the property. Then you'll have every asset in the building on the proper depreciation schedule whether it be 5, 7, 15, 27.5 or 39 year. Depending on the cost of the property the benefit for having every asset on the proper schedule could mean tens of thousands in tax savings. It all depends on the specifics of the property and if you paid for the build out or if the tenant paid for the build out. 

Or you could just put it all on 39 year as most people would do. The IRS generally doesn't complain when you're overpaying tax due to incorrect depreciation.

If you want some more info or to see some real numbers just let me know. 

@Sarah D. You're mostly right here with a few caveats. First off you're right on most of it: carpet is 5 year, appliances are 5 year, landscaping is 15 year, but the vinyl plank could go either way 5 or 27.5 depending on how installed, and for everything else it'll be a mix of 5 and 27.5: lots of the kitchen stuff would be 5 year and the bathroom stuff would be 27.5. The thing is it's all based on the facts and circumstances of the individual assets there's no bright line test there's 6 factors used to determine if something is 5 year or 27.5 year. That's why it requires an engineering analysis to be done properly.

 The biggest issue with depreciation when it comes to rehabs is removing the cost of everything that was torn out from your cost basis. If you start depreciating the new improvements without removing the cost of the replaced items you're technically still depreciating retired assets and the IRS doesn't like that since it's technically tax fraud. 

Let's say you bought that 4 plex for $300K with $100K in the land and $200K in the building. Then you tore out $20K worth of old stuff and put in $50K worth of improvements. Your depreciable cost basis should be $230K, not $250K since $20K was retired. Make sense?

As for just doing everything at 27.5 year that is what most people do but it's incorrect since in the event of audit the IRS could come in and disallow further depreciation of short life assets once their depreciable life is over.

Really the only way to have everything properly depreciated is through forensic engineered cost segregation since everything is entangled with the original property cost.

You'd be surprised how much benefit there can be hiding in a 4plex. I had a client who had 2 4plexes he purchased together and the tax benefit we got him was over 4 times the cost of the study, over 5 times after accounting for the after-tax cost of study.

Of course everything depends on the specific situation, and if you want to see some real numbers for your property just let me know.

You can't expense out a roof, so scenario #1 doesn't work. De minimis safe harbor rules say you can expense out items up to $2500. When something is expensed out it's not put on the depreciation schedule since it isn't being depreciated. You get to fully deduct that expense in the current year and it is not recaptured. If you just did repairs that can be expensed, but depreciable assets must be depreciated according to the class life set in MACRS. It'd be 27.5 years on a roof in a rental property. Also you must keep in mind that the depreciable cost basis is the improvement value (the building and any improvements to the property) and the land value is non depreciable. 

If you really want to know what the rules are for rental properties read IRS Publication 527: Residential Rental Property It's only 24 pages and goes over all the tax code that applies to rentals. 

Depreciation will be recaptured at a maximum of 25% so $10,000 in depreciation would have a tax bill of $2,500 upon sale of the property assuming you are at or above the 25% marginal tax rate. Recapture is based on depreciation taken or allowable, usually whichever is more. 

So in your scenario the reality would be something like this: $120K purchase with $100K improvement value and $20K land value. $100K is the initial depreciable cost basis. You replace the roof for $5K so now your adjusted cost basis is $105K at the beginning. Since it's 27.5 year asset lives for rental property after 10 years you've depreciated 10/27.5 = 36.36%. So take the adjusted cost basis from the beginning $105K x 36.36% = $38,181.81 depreciation taken in years 1-10. Your new adjusted cost basis after 10 years would be $105K - $38,181.81 = $66,818.19. So you've been getting a $3,818.18 tax deduction from the depreciation each year for 10 years. When you sell the property the depreciation is recaptured at 25% so you're looking at $38,181.81 x 25% = $9,545.45 depreciation recapture tax. If you sell the property for $125K (Original value = $100K improvement + $20K land + $5K roof) there would be no further capital gains taxes. If you sold it for $130K you would have $5K of capital gains taxed at 15% = $750 capital gains tax. If you sold it for $120K you'd have $5K in capital losses which would be disallowed and carry forward into the next tax year unless you had other capital gains to offset the losses. You could subsequently get $5K in capital gains tax free by the offset. 

Hope this helps clear up some of your questions. I'm sure you've heard this before, but it's a good idea to talk to a CPA that knows real estate to figure out all the tax stuff in the best way.

Depreciation starts when the property is placed in service regardless of where you live. 

Once you place the property in service as a rental you can depreciate the entire property except for the land is non depreciable. The septic system would be residential rental property at that point so you can depreciate it over 27.5 years. 

I highly recommend taking a look at IRS Publication 527 for info on cost basis and everything else related to taxes on your rental. 

Those numbers look correct to me. There are a bunch of things that can adjust the basis up or down so make sure you've accounted for everything. 

Did you place the rental in service in June? It's placed in service when it's ready to be rented regardless of if its rented or not. So unless you had a tenant lined up and it was ready on July 1st; I'm guessing you advertised it and it was ready in June with a July 1st start date. So if it was placed in service in June (or earlier) you use a mid month convention starting in June 2016, so you get 6.5 months of depreciation on the residential rental property which depreciates over 27.5 years. That's 1.970% depreciation in 2016 for June in service date. 

Both the $2800 driveway widening and $3000 deck would be land improvements that get depreciated over 15 years with a mid quarter convention. Depending on if they were done in April-June or July-September they'd be either second quarter or third quarter with 6.25% depreciation or 3.75% depreciation in 2016. 

Beyond that there are assets that would be considered tangible personal property that get depreciated over 5 years within the residential rental property. That's where things get a bit too technical when you start looking at the nuts and bolts of the property for depreciation. There's generally at least 10% of the cost basis that qualifies for accelerated depreciation on property over $200K less land. 

So in that $257K cost basis there could be $25K-$35K+ in tangible personal property depreciated over 5 years with 200% declining balance accelerated treatment and a mid quarter convention. so depending on the placed in service date either second quarter or third quarter for either 25% depreciation or 15% depreciation in 2016. 

As you may imagine with a larger property accelerated depreciation can be quite beneficial. Here's the thing: you're not supposed to just say 10% of the cost basis is tangible personal property, you're supposed to have actual documentation that 15.2% of the cost basis is tangible personal property, 10.3% of the cost basis is land improvements, 74.5% of the cost basis is residential rental property and descriptions of everything. 

The process of identifying assets for proper depreciation classification is called cost segregation. A forensic engineered cost segregation study is performed by a qualified construction engineer with a site survey followed by 4-6 weeks of number crunching and preparation of documentation. 

Because of the high level engineering work and time required for such studies they were initially reserved for high priced properties over $5 Million since early studies cost over $100K and were only done by large accounting firms with engineering departments. Independent cost segregation firms have brought the costs down considerably and now any property owner can get a cost segregation study for a few thousand depending on the size and complexity of the property.