All Forum Posts by: Paul Caputo

For residential rental property you have to use a mid month convention for depreciation. That means that when you place the property in service it is considered placed in service at the mid point of the month regardless of the actual date. So yes, 1.5 months or 0.455% depreciation in 2016 for property 1 and 0.5 months or 0.152% depreciation in 2016 for property 2. Remember you can only depreciate buildings/improvements and land is non depreciable. You'll have to file Form 4562 with your tax return.

Check out "Conventions" on page 9 of IRS Publication 527: Residential Rental Property for info about the mid month convention. On other MACRS property you would use a mid quarter or half year convention as applicable. There are also abbreviated depreciation tables on page 11. 

https://www.irs.gov/pub/irs-pdf/p527.pdf

Depending on the cost of the properties there could be a significant amount of assets that qualify for accelerated depreciation. If so accelerated depreciation would substantially lower your taxable income and increase your cash flow. In order to get the maximum allowable depreciation on the properties you could do a cost segregation study. 

@Andrew Great Look up your property taxes. Assessed land value should be in there. Then you take it proportionally from the assessed value to the actual price you paid. 

I'm guessing you don't have a CPA because they would do this for you. It'd probably be a good idea to talk to a CPA.

Yes. When you sell depreciable property you must recapture all allowable depreciation. So even if you don't take all allowable depreciation the IRS will treat the sale as if you did take all allowable depreciation which is what is subject to recapture. Recapture is at a lower rate than you initially took the depreciation, plus it's in unknown future dollars that are worth less than today's dollars. 

The thing that is difficult for many people to understand is that the benefits of accelerated depreciation are in the time value of money. The guiding principle is that a dollar today is worth more than that same dollar tomorrow (or any future date years down the road). This makes sense when you think about it. You could buy a lot more with $100 20 years ago than using that same $100 today. 20 years from now that same $100 today may only be worth $75 in future dollars. 

Imagine the IRS says they're going to give you $100, but you must repay it at some unset point in the future. They give you two options on how to receive this money: over 5 years with accelerated treatment or over 27.5 years with straight line treatment. If you take it over 27.5 years you get $3.63 per year for 27.5 years. If you take it over 5 years you get $40 in the first year, $24 in the second year, $14.40 in the third year and $10.80 in the fourth and fifth years. 

The idea is that the sooner you receive this money the sooner you can reinvest it into something that will produce a return instead of just letting it sit there in the US Treasury waiting to get it little by little and reinvesting the small portions each year. 

So just looking at it year by year shows an obvious windfall in cash flow over the first 5 years, but the key is to make the money work for you. 

This is how it would look: For simplicity sake let's say you hold the cash for the first 5 years and then reinvest it. In the 5 year example you'd have $100 to invest after 5 years. If you then put that $100 into something that compounds annually and has an 8% interest rate for 15 years you'll end up with $317.22 after 15 years of investment, 20 years since purchase. In the 27.5 year example you'd have $18.18 to invest after 5 years. If you put that into the same investment that compounds annually and has an 8% interest rate for 15 years plus you get to add another $3.63 to it every year you'll end up with $164.12 after 15 years of investment, 20 years since purchase. 

So after 20 years you would either have to recapture $100 with $317.22 available or recapture $72.72 with $164.12 available. Now the thing here is that recapture maxes out at 25% while the actual depreciation is dependent on your marginal tax rate. So in a "perfect" situation you're at the top marginal tax rate of 39.6% for the actual depreciation and recapture at 25%. In this situation your recapture is only 63.13% of the actual depreciation. So your true recapture would be $63.13 vs your $317.22 available or $254.09 surplus after recapture on the 5 year example; Or your recapture would be $45.90 vs your $164.12 available or $118.22 surplus after recapture on the 27.5 year example.

So there you have it. It absolutely makes more sense to accelerate depreciation whenever possible. The reality is they don't just give you $100. The $100 here is the entire building/improvement value and the rules for depreciation are quite complex. Out of that $100 there could be $10-$30 classified as 5 year assets, $10-$20 classified as 15 year assets and $50-$80 classified as 27.5 year assets based on the facts and circumstances of the property. Since every property is unique you need to have documentation to substantiate your depreciation. The only way to do this that is accepted and approved by the IRS is to have a qualified construction engineer or architect do a cost segregation study on the property. 

That's crazy. It doesn't cost $5K to recreate blueprints. How big is the property and what is it? Have you gotten a second opinion? Because that doesn't make any sense. You have to be careful with cost segregation because of the lack of uniformity in the industry. 

If you don't have blueprints the construction engineer should be able to recreate the blueprint after doing the site survey. Does it make sense to you that recreating some drawings would more than double the cost of the study? 

It would absolutely be extra work and take some time to do the drawings leading to a higher cost, but that sounds ridiculous. 

Commercial property and rental property generally must use MACRS - Modified Accelerated Cost Recovery System. Accelerated cost recovery is a fancy way of saying accelerated depreciation. That's a big misconception about accelerated depreciation and cost segregation: many think it's only applicable on large commercial properties costing over $5MM, while it actually applies to virtually every commercial and rental property placed in service since 1987. 

It's absolutely true that the higher the cost of the property the greater the benefits from accelerated depreciation. So it's usually more lucrative with commercial property, but the benefits are generally still substantial with rental property.

The overwhelming majority of eligible taxpayers miss out on accelerated depreciation because they are simply unaware of the benefits they would receive. The government wants you to invest in real estate to stimulate the economy. Accelerated depreciation is a very big carrot they wave in front of your face to do just that. 

It makes sense when you think about it: basically everything that qualifies for accelerated depreciation usually gets replaced within 5-15 years as opposed to building components that tend to last closer to their full lives of 27.5 or 39 years. When those long life assets give out like when you have to replace the roof after 12 years if you have the proper documentation you can expense out the remaining depreciation on the component when you replace it and start a new depreciation clock on the new asset. Without cost segregation this wouldn't be possible as there would be no cost basis for the original roof it'd be lumped together with the rest of the property. 

You recapture all depreciation when you sell. Doing a 1031 exchange will just defer that recapture until you sell without doing a 1031 exchange. So if you keep exchanging you could theoretically never pay the recapture. The idea is to keep exchanging up in value so you get more depreciable cost basis on every exchange. 

The IRS doesn't treat a 1031 exchange like a sale it's an exchange so the depreciation schedule just moves over to the replacement property. So you've had 12 years depreciation on the Breckenridge rentals so when you exchange you'll have 15.5 years left of depreciation on that transferred basis. 

Since the market has gone crazy up in the mountains I'm guessing you bought the 2 condos in Breckenridge for $100K 12 years ago and you're gonna be able to sell them for $400K right? So that's how you get to the $400K vacation home in Hawaii? Nice choice by the way! After you 1031 you'll have the remaining depreciation from the $100K and start new depreciation clocks on the excess basis of $300K over the unadjusted basis of the original property. 

If you use the Hawaii property as a rental for 3 years and then live there for 2 years you can only take 40% of the capital gains as a section 121 exclusion since there was 60% non qualified use, but the cap remains the same $250K single/$500K married filing jointly. 

@Dan Bryskin you're on the right track with the cost segregation study. Except you can't accelerate the windows since they are considered building components, but cost segregation would allow you to expense out the remaining depreciation on the old windows when you replace them. 

Accelerated depreciation is the biggest untapped resource in real estate investing. If everyone understood how it works everyone would do it, but over 97% of eligible taxpayers have not done cost segregation. This is mostly because people either don't know about it or think it's too expensive. After receiving the tax benefits no one thinks it's too expensive, they recognize it's one of if not the best investment they've ever made.

The benefits are larger when you're at a higher marginal tax rate, so this should be utilized by almost every investor especially high income earners. 

@Ken Wang PM me for details, accelerated depreciation will substantially lower your taxable income over the next 5-10 years.

If you demo the whole thing it's new construction. If you leave something structural it's renovation. With proper documentation you could expense out everything that is demo'd or removed and then start new depreciation clocks on all the new improvements. But you gotta plan it right and account for everything. 

Awesome story and congrats on the successful house hack! I'm just north of Denver so this gives me some local inspiration! It's nice to see local success stories. 

@Wesley Emison is right about cost segregation. The tax benefits from accelerated depreciation are quite impressive. The depreciation catch up provision is a section 481(a) adjustment that allows you to take any previously unclaimed depreciation in the current year and carry forward into future years if the adjustment is large enough. 

On a $300K property you'd probably see $10K-$25K in tax benefits over 5 years depending on your tax rate, land value and the amount of tangible personal property in the home. For many investors this puts their taxable rental income close to zero and maximizes cash flow. 

The best part is the IRS accepts and approves engineered cost segregation studies so they actually want you to do this. It's one of the few instances that the IRS wants you to do something that will substantially lower your taxes. Depreciation is the greatest untapped resource in real estate, and engineered cost segregation is how to get the most out of it. 

Be careful with it though and only accept a true engineered cost segregation study done with a site survey by a construction engineer or architect qualified in cost segregation. Anything less does not follow IRS guidelines and can open you up to fines and penalties. 

You're absolutely right @Scott Davidson it's the adjusted basis not the purchase price. Thanks for keeping me on my toes! @Jason Kimery You also need to consider land value in your calculations since land is non depreciable. Your adjusted depreciable cost basis would be purchase price less land value (land is non depreciable) plus improvements (improvements are supposed to be depreciated separately, but for simplicity sake most just add it to the basis) less any depreciation/losses already taken (this should be zero in your case since there wasn't depreciation/losses while it was your residence unless there were casualty losses when it was your residence)

On the improvements it depends on what they are for depreciation purposes. Anything that is a structural component of the building or necessary for the general operation and maintenance of the building is considered residential rental property depreciated over 27.5 years. Everything else in the building is tangible personal property depreciated over 5 years. Any improvements outside the building are land improvements depreciated over 15 years. The actual rules on this are quite complex and depend largely on the facts and circumstances of the property. Because of the complexity and potential for fines and penalties for getting it wrong most just "play it safe" and depreciate everything over 27.5 years unless they can substantiate the improvement cost and asset classification. Problem with that is if the IRS find you're depreciating a 5 year asset over 27.5 years they can disallow further depreciation after year 5. That's probably not going to happen, but it is possible. 

No one likes to hear this, but the correct way to depreciate is using the Modified Accelerated Cost Recovery System (MACRS) and the Final Tangible Property Regulations. An engineered cost segregation study is the easiest way to apply MACRS and the tangible property regulations, but on a single rental the cost of the study could be too high to make financial sense.