All Forum Posts by: Paul Caputo

Bonus depreciation is great you get to take 50% bonus depreciation on property placed in service in 2017, 40% in 2018 and 30% in 2019. So if you need one more reason to do stuff now there it is. 

Cost segregation isn't aggressive at all, it's accepted and approved by the IRS. It's simply putting together the documentation to depreciate property according to MACRS. The truth is it's bringing the taxpayer into full compliance with the tax code with respect to depreciation. 

Happy to help! When you're looking at bigger properties it generally makes sense to go an extra step and do an engineered cost segregation study to get the depreciation benefit maximized, but on a property this size the benefits of accelerated depreciation would be minimal so it wouldn't be worth the cost of a study.

It's way more complex than your purchase price or estimated ARV, you'll end up somewhere in the middle because you're gonna fix the place up. Depreciation is an incentive to businesses to buy property in the form of a tax deduction tied to the actual value of the property. So no you can't use a higher number than what you actually paid. Even though it'll be worth more on the open market than what you put into it the IRS doesn't care about market value, they care about what you paid.

If you get it for $86K that's you're starting point. From here you need to remove the non-depreciable land value according to your tax assessment or appraisal to get your depreciable property value. Land value is usually about 20% but it varies. So just to make it easy say that $86K is really $16K land and $70K building. So your starting depreciable cost basis would be $70K. Then you fix the place up say you put $50K into rehabbing. You then have an adjusted depreciable cost basis of $120K: the initial basis plus the improvements. Does that make sense? 

Truthfully you're not gonna know what your adjusted cost basis is until AFTER you complete the rehab. You won't lose any depreciation while you're doing the rehab work since the rental isn't ready to use yet so don't worry about that. Once it's ready to be rented it's placed in service and that is when depreciation begins.

Your CPA is right and wrong. The IRS doesn't care if your CPA is right or wrong, all they care about is if you paid what you're supposed to pay. 

In your example your CPA has actually been under-conservative as opposed to the over-conservative stance he thinks he's taking. Bathrooms are specifically included in general maintenance or operation of a building for "human comfort" and are therefore considered 1250 property depreciated over 27.5 years for a rental or 39 years for commercial property. So even though many of the things in the bathroom that you replaced would be 1245 property elsewhere in the building, since it's in the bathroom it doesn't qualify. Say you remodeled the kitchen on the other hand: most of those improvements would be tangible personal property and qualify for 5 year accelerated depreciation as 1245 property. The problem is there are no bright line tests for reclassifying property as illustrated above. All sinks are not depreciated equally, it depends on where they are and how they're used. It's all based on the facts and circumstances of your individual situation. 

Restorations are considered improvements, because you had an asset that had fallen into disrepair you improved it by restoring it to original usefulness. If the asset hadn't fallen into disrepair you wouldn't have had to restore it. Does that make sense? More broadly basically anything tangible in the property would be considered an improvement. The entire building is an improvement on the bare land. 

Problems arise when you don't get it right. Depreciating that bathroom over 10 years (Very few things with 10 year lives unless you're manufacturing sugar or vegetable oil or using ADS which you shouldn't do unless required, not sure where he pulled that number) when it should be 27.5 years gives you almost triple your allowable depreciation per year. The IRS doesn't like that so it opens you up to fines and penalties. But inversely say it's the kitchen stuff and depreciating it over 10 years when it should be 5 years gives you half your allowable depreciation and then the IRS can disallow further depreciation in years 6-10. No fine or penalty but you only get half of what you should've. 

You basically have three options when it comes to depreciation: 

The easy way - lump everything together as 1250 property and depreciate over 27.5 years.

The Quasi-right way - Do simple cost segregation from your records with your CPA to classify some things as 1245 property depreciated over 5, 7 or 15 years and some as 1250 property depreciated over 27.5 years. The issue here is getting it right. Hint: this is never 100% accurate.

The best way - Have an engineered cost segregation study breakdown the property into tangible personal property depreciated over 5 years (7 year is rare, but possible), land improvements depreciated over 15 years and building components depreciated over 27.5 years. A study provides the necessary documentation to substantiate the reclassification. 

You do need to bear in mind that if you are planning on doing a 1031 exchange in the future and do cost segregation the replacement property must have comparable levels of 1245 property and 1250 property or you could be looking at a big tax bill. The intelligent way to go about that would be to have a cost segregation study on the replacement property as well. This double cost segregation strategy works best when you are trading up in value considerably with the replacement property.

A nice thing about this is it doesn't require any amended returns and the IRS lets you catch up on previously unclaimed depreciation with a section 481(a) adjustment in the current year that is given automatic consent by the IRS Commissioner. I'd recommend never filing amended returns because that can cause an Audit.  

If you were investing in anything else would you consider an investment that loses over $20,000 a year? Of course not. I think too many people get caught up in trying to house hack and make an owner occupied multi-family work when it may make more sense to live in one place and do business in another. Even if you got this place and rented all 3 units and lived elsewhere you'd still be losing money on it or barely breaking even. If you want to live there because you want to then the liability is worth it if you deem it to be, but if it's solely a business decision I think you already answered your own question.

On the tax side the depreciation would only apply to the rental property in proportion to the entire property. On a $1.75M property you'd generally have about 20% land value (The actual number would be in the tax assessment and appraisal) so you're looking at about $1.4M cost basis for the actual building. You allocate that based on square footage, so if all three units are the same size each gets one third of the cost basis, but if the main house is the size of the other two units combined then it'd be half to the main house and a quarter to each smaller unit. So if they're all the same size your depreciable cost basis from the rental property would be 2/3 of $1.4M or about $933K. So your annual depreciation on that would be $933K/27.5 or $33.9K so you'd more realistically be looking at around $11K in tax savings per year, not $21K. 

Of course you could do an engineered cost segregation study to reclassify some of that depreciation to 5, 7 or 15 year asset lives with accelerated treatment. This allows you to take more of the depreciation sooner and in turn lowers long life depreciation. Due to the time value of money this can have a huge positive impact on any real property transaction. The idea here is instead of getting that $11K in tax savings every year for 27.5 years you'd get $20K in tax savings for the first five years and $9K in tax savings for the remaining 22.5 years. Those numbers aren't exact of course, just illustrating the point. On property over a million dollars the tax savings from cost segregation can be between $50K-$100K+ so it should be seriously considered with every major purchase of commercial or rental property. 

If you have specific questions on cost segregation please feel free to PM me.

@Tanya Patience It's not what "makes more sense" there are actual rules for what you should do. The Final Tangible Property Regulations give guidance on what to do, but it's best to get a CPA involved since they're gonna be able to help you out here. Your carpet example is technically tangible personal property that should be depreciated over 5 years, but you could be eligible to elect the de minimis safe harbor exemption since it's under $2,500 ($500 if before January 1, 2016 so if it was then it wouldn't qualify) which would allow you to expense it in the current year rather than capitalize and depreciate. But being under $2,500 is not the only requirement, your total safe harbor expenses for the year have to be under $10,000 or 2% of unadjusted cost basis whichever is lower. 

Financially it depends on your entire financial picture. Deductions are worth more when you're at a higher tax rate. If you're showing losses on your properties and have significant other income I'd expense as much as possible to lower your overall taxable income further. If you're showing losses on your properties and do not have significant other income then further reducing your taxable income wouldn't do much to help you. You could potentially carry forward those losses into future tax years but there are restrictions on that. A $100 deduction is only worth $15 in tax savings at the 15% tax bracket, but the same $100 deduction is worth $35 in tax savings at the 35% tax bracket. The other thing to consider is depreciation recapture. Expenses are considered costs in the current year so when you sell the property down the road you don't have to repay those deductions. With depreciation you have to repay it upon sale of the property they call that depreciation recapture and it is taxed at a maximum of 25% depending on your marginal tax rate. 

I know no one likes this answer, but the truth is ask your CPA there's not really a one size fits all answer here it depends on your individual situation and long term plans. Generally it makes more sense to expense everything you can since you get the full deduction now and don't have to recapture. It gets trickier to know what can and cannot be expensed, and even more so when you factor in personal finances and the impact of these decisions over time. 

She can sell the house to you at whatever price she wants, but fair market value or what she originally paid would make the most sense. Since you're related parties any gain would be taxable as ordinary income and any loss would be nondeductible so it'd be best to make the transfer price so that there isn't any gain or loss so she can avoid paying tax on the gains or losing out on taking the loss. 

Since you and your mom live there if you convert it to an owner occupied rental only the portion that is being rented would be considered rental property and the rest would be personal real property. Unless your mom pays you fair market rent for her portion of the property it would still be personal property. At $1200-$1350/month for a 3 bedroom home that's $400-$450/month per room. So you're either looking at about $400 or $800 per month in rental income depending on if you charge mom. 

Before you go through all that trouble take a step back and consider if your long term plan makes sense. If your mom didn't own this house would you want to buy it, fix it up and hold it as a rental? If not it might make sense to sell it to someone else and use the proceeds to get into another property that better suits your goals. With all that rehab needed it may be quite difficult to find a tenant who will pay market rent for sub par accommodations. Even if you move and fully rent it out how long will it take for your cash flow to recoup those rehab costs? Probably a decade or so. 

You'll only be able to do a wraparound if mom's original loan doesn't have a due on sale clause and the lender allows the wraparound. Usually they have higher interest rates than the initial mortgage so that should be taken into account. If her mortgage is assumable then she can transfer it to you, but since you said there's no issue with you getting a mortgage or down payment there's not much reason to pay the extra interest. 

@Rehana Shrestha If you were just holding that property and didn't use it for any business purpose there wouldn't be any depreciation. Depreciation starts when the property is placed in service. Since you didn't have a tenant or any other way to justify it being considered a rental property it was never placed in service. But like @Nick C. said check with your accountant they'd be able to get you all squared away and they'd probably find deductions that you overlooked. 

Check out IRS Publication 537 - Installment Sales for more info on how this works.

https://www.irs.gov/pub/irs-pdf/p537.pdf 

@Wayne Brooks you are correct: the seller would get hit with depreciation recapture in the year of sale assuming it was a rental being depreciated. If it was his residence it was non-depreciable so there wouldn't be any recapture since there was no depreciation and as long as the gain is under $250K he could get a section 121 exclusion on sale of primary residence. Now if it was a rental any gain beyond the depreciation recapture would be taxed on the installment method. So it really depends on how he used the property. 

If it's depreciable there's always gonna be recapture upon sale unless the basis is transferred with a 1031 exchange and that doesn't seem likely in this situation. He'd have to pay recapture because the tax benefit of depreciation is tied to ownership. When you no longer own the property, you're no longer entitled to those tax benefits and have to repay them regardless of how the sale is setup (other than a 1031 exchange) This catches a lot of people off guard when they realize they owe recapture and should be considered before the sale. Generally the sale proceeds are more than enough to cover recapture, but in this situation looks like you might have him between a rock and a hard place.

I used to sell carpet and getting rid of it will solve a big headache. When seeing a new place for the first time people look around then look down almost immediately. Carpets get dirty and gross pretty easily especially in a rental and the carpet manufacturers will not warranty "residential carpet" in a rental property, it has to be specifically warranted for commercial or rental property and that's usually only really thin hard loop carpet that you see in office buildings. So even though the carpet is cheaper you're gonna have to keep replacing it every few years to attract good tenants. 

Throw down some strong laminate or vinyl planks or sheets (I'd probably do vinyl, if it's strong it'll last longer than laminate and vinyl doesn't care if it gets wet so easy cleanup!) and you won't have to worry about the floor getting messed up again. Also If you do a laminate or vinyl plank floor if one board gets messed up it can be replaced without redoing the whole floor, bad carpet stains and you have to replace the whole room for it to look ok, and if the carpet doesn't all match it looks bad. Also if you allow pets it's a no brainer to get rid of the carpet since the urine smell never goes away when it gets down into the padding, but with vinyl that's easy cleanup. 

I'd stay away from solid hardwood floors in a rental. It looks great initially and is very strong, but a tenant can easily scratch it and mess it up and it's generally the most expensive floor you can buy. Then you have to refinish it every so often which can be half the price of the initial floor investment. Also if it's floating laminate, vinyl planks or engineered hardwood it qualifies for accelerated depreciation over 5 years while a solid nailed down hardwood in a rental is depreciated over 27.5 years. 

Touching up the paint, cabinets and fixtures are all helpful in making it rent ready, but the floor is very important. Most of the other stuff can be done fairly easily, but the floor will take the most work unless you're doing serious remodeling like a new kitchen or bathroom.

On your improvements and repairs make sure you keep all your receipts and give them to your CPA. Some of that could be eligible to be fully expensed while some would have to be applied to your cost basis and depreciated with the building.