Ah, depreciation, the great phantom expense that shelters our rental income from the tax man every year. For those of you who do not know, depreciation is a reduction in the value of an asset with the passage of time due to wear and tear. To encourage investment, the IRS allows depreciation expense to be written off each year as a means to recover the cost of the investor’s initial investment.
It should be understood that depreciation isn’t an efficient means to recover the cost of your initial investment, mainly because you have to recover the cost over a number of many years. In fact, when my clients come to me with a “repairs vs. improvements” scenario, I try my best to classify items as repairs because we get to deduct the expense and subsequently recover the cost in the current year, rather than depreciate it over many years. A motto all CPAs should live by: “A dollar today is worth more than a dollar tomorrow.”
That being said, there are times you won’t have a choice but to depreciate certain costs, the largest of which will be the overall acquisition cost and the focus of this article from here on.
I’m not going to walk you through a HUD statement and tell you how to account for each line item (maybe a future article), but I will teach you the methodology I use to show the largest “improvement” value for a client after the purchase of a property. As you know, only the cost of improvements can be depreciated, as the IRS takes the stance that land does not deteriorate and lasts forever. Because of this, we must allocate the purchase price between land and improvements, with the goal of allocating as much of the value to improvements to increase our annual depreciation expense.
An example to show you what costs can be depreciated:
You purchase a property for $100k. The property card says the land is valued at $25k, and that’s the value you decide to use. You determine your improvements are $75k, which is the amount you are allowed to depreciate over 27.5 years. The $25k of land is not able to be depreciated.
If the above example describes you, I suggest you bookmark this article and reference as needed. Most people don’t give their land value much thought at all. They simply list the land value on their property tax card and call it a day. But as I will discuss below, there are several methods you can use to yield a higher improvement value and subsequently much better depreciation results.
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Methods to Calculate Depreciation
You can utilize several different methods to calculate depreciation, and the IRS doesn’t indicate which they prefer you use. Ultimately, it’s up to you to decide how to allocate the purchase price between land and improvements, and as long as you can support your calculation, you will likely hold up during an audit. You always want to have the ability to support your decision making; otherwise, you may end up in a situation where the IRS doesn’t agree, causing you to pay back a portion of what has been written off over the years.
There are three methods I have used in the past to determine improvement vs. land value and subsequently depreciation for myself and my clients. While it is important to utilize all of these methods and use the one that gives you the best result, I have listed them below in order of level of effort and how well the method will support a calculation. After all, you don’t want to spend a lot of time using one method only to find out it doesn’t hold up in the event of an audit.
- Property Tax Card
- Buyer/Seller Appraisals
- Replacement Cost and Land Sale Comps
In each of these methods, I seek to find the best “improvement ratio.” An improvement ratio is the value of the improvements divided by the total value of the property (land + improvements). I then apply the best (largest) improvement ratio to the purchase price of the building, and that becomes the basis of the property which will be depreciated over 27.5 years (39 for commercial).
I’m going to walk you through each example using my most recent purchase and the numbers associated with it. My purchase price was $91,800.
Method One: Property Tax Card
This method requires the least amount of effort and is one of the best ways to substantiate your calculations. The property tax card for my property lists the land value at $27,500 and the improvement value at $105,000, for a total value of $132,500.
My improvement ratio = $105,000 / ($105,000 + 27,500) = 79.92%
An 80% ratio isn’t bad, but I’d want use the other methods to see if I can increase it. In my experience, I’m able to safely use roughly an 85% improvement ratio.
To calculate my depreciable basis, I apply the ratio of 79.92% to my purchase price of $91,800 and end up with a depreciable basis of $73,367 and a land value of $18,433. The depreciable basis will result in annual depreciation of $2,668.
Method Two: Buyer/Seller Appraisals
I list this as the second best method only because it takes more effort to pull off in that you likely have to pay for the appraisal to be done. This method will substantiate your calculations just as well as method one above.
The appraisal that I had completed on my property indicated that the value of the improvements are $147,816, and the value of the land is $20,000, for a total value of $167,816.
My improvement ratio = $147,816 / ($147,816 + $20,000) = 88.08%
To calculate my depreciable basis, I apply the ratio of 88.08% to my purchase price of $91,800 and end up with a depreciable basis of $80,859 and a land value of $10,941. The depreciable basis will result in annual depreciation of $2,940, which is an increase over method one of $272.
Method Three: Replacement Cost and Land Sale Comps
This method is listed last because it takes the most effort and is more questionable in terms of whether you can fully support your improvement ratio calculations.
Replacement cost is the cost to construct a brand new building substantially equal in size, shape, and style to the one you currently own. You can gather information about your replacement cost from a variety of sources, most commonly your appraisal report and insurance estimates. An appraisal report will likely be the safer option unless an insurance agent physically conducts his/her own appraisal or analyzes the appraisal report. For purposes of showing readers a variety of methods, I will assume the insurance agency sent their own agent to conduct an appraisal, and we will use their replacement cost of $255,000 in the quote they provided me.
Land Sale Comps can also be found from a variety of sources, including third party websites, county offices, and agents with access to the MLS. When I conducted my study, I found land sales comparable to my lot were about $30,000.
My improvement ratio = $255,000 / ($255,000 + $30,000) = 91.07%
To calculate my depreciable basis, I apply the ratio of 91.07% to my purchase price of $91,800 and end up with a depreciable basis of $83,602 and a land value of $8,198. The depreciable basis will result in annual depreciation of $3,040.
Now, I think that using an improvement ratio of 91% is too aggressive for the extra amount per year that I’d be able to write-off. In any decision making scenario, you need to fully analyze the costs vs. the benefits.
That being said, I also think the calculation from method one (80%) is too low. Like I said, I like to see around an 85% improvement ratio. In this situation, I averaged my three ratios of 79.92%, 88.08%, and 91.07% and received a final ratio of 86.36%. Applying this ratio to my purchase price of $91,800, I have a depreciable basis of $79,278, a land value of $12,522, and annual depreciation expense of $2,883. I’m comfortable with this calculation and confident that I can easily substantiate my basis in the event of an IRS audit. By averaging the results of the three methods, I actually provide more support for my calculation, and it is right where I want it to be.
Don’t overlook this relatively simply yet extremely important calculation. Calculating your improvement ratio to increase your annual depreciation expense is arguably one of the most important calculations you will make. And always remember to keep the documents you used to support your calculations.
Investors: How do you calculate your improvement ratio? Have any questions about the method I use?
Leave your comments below!