A wise man once told the world that there are only two certainties in life – death and taxes. It doesn’t take a genius to figure that one out (sorry Benjamin Franklin).
Some people will unknowingly travel a great distance to elude one or the other. One of those individuals is my friend Bob.
Bob’s almost retired, and because Bob is a “small” real estate investor, he tries to save money whenever he can. That’s why Bob mows the lawns, manages the properties, and balances the books by himself.
An even wiser man told me a few years ago that there are three certainties that I should know about – death, taxes, and the regret that I would live with for the rest of my life if I didn’t maximize depreciation on my rental properties…
I thought I would regret the 25% depreciation recapture tax if I ever decided to sell my rentals. That’s because Bob used to say to me “all that depreciation stuff is a waste of time. You have to recapture the deductions at 25 percent anyway…”
Being a new investor back then, I wasn’t exactly sure what Bob was talking about, so I went and talked to my tax advisor. He explained to me that when I purchase an income producing asset, like an investment property for my rental business – I don’t get to immediately write off the acquisition cost of the asset. Instead, the cost of my asset must be recovered over the useful life of the asset. This is called depreciation, and the IRS has ruled that residential rental property is depreciable over 27.5 years. Depreciation is a phantom paper expense that reduces your taxable profit.
I bought a single family home for $165k, and it generated $12k from rent that year. I had $8k of expense deductions, so it appears I should have claimed $4k in rental income and paid online taxes on it. However, this rental property gave me a depreciation deduction of $6k ($165k/27.5 years), which allowed me to claim a $2k rental loss that I could take against my regular income. At a 28% federal tax rate, the additional depreciation deduction was allowing me to pay $1,680 less in taxes (28% * $6k less income). Eventually, I came to realize the benefit that depreciation was providing me – it was allowing me to owe less in taxes, even when I was making more profit.
Soon enough, I learned about separating my assets and segmenting my deductions, and it was saving me thousands of dollars more. People normally depreciate their properties using a straight-line deduction over 27.5 years. However, residential properties have shorter-life assets – like a refrigerator or a fence – that can be separated and depreciated sooner over 5 or 15 years. I identify these assets and depreciate them separately so I can take the deductions sooner. With the accelerated, higher deductions, I can reduce my tax liability and save thousands of dollars.
Using straight-line depreciation on a $275k property can yield a $10k yearly depreciation deduction, so $50k can be deducted over five years. However, the property might have $50k in 5 year assets (carpets, appliances, drapes, etc…) and $25k in 15 year assets (driveway, fence, patio, etc…). Depreciating these assets separately according to IRS class lives allows nearly $100k to be deducted over the first five years – almost twice the deduction from straight-line.
Three years later, I wish I could travel back in time to let Bob know that I disagree with him. Back then, I vaguely understood that the accumulated depreciation deductions would get recaptured and taxed at a rate of 25% upon the sale. This was Bob’s main concern, and he was worried about owing back a lot of money on the depreciation deductions he would have taken, if he ever sold his rental property.
The reality is that the IRS wants us to take timely depreciation deductions – that’s why they created the rule. They even know some of us want to separate assets and segment deductions according to useful class lives – that’s why they ruled on depreciable lives for common assets found in properties. If we ever sell our rental properties, the IRS will recapture the depreciation that we should have deducted – even if we never took any depreciation deductions! The important thing to learn here is that the IRS says we have to depreciate, and if we don’t, we lose the tax benefit – so we might as well follow the rules and use them to our advantage by maximizing depreciation deductions, right?
With straight-line depreciation, we get the same deduction every year – meaning our depreciation deduction in year 3 is the same as the depreciation deduction in year 23. Accelerating deductions simply means we deduct more now instead of later. Having a larger deduction now means we also have a smaller tax bill now – so why don’t people do it?
Generally speaking, there are two main reasons why investors might use straight-line depreciation. One is passive-activity limitations. Taxpayers with an AGI above $150k cannot deduct any rental losses against their wage income – the loss must be carried forward until it can be offset with future rental income. Therefore, a high income taxpayer who already has a rental loss carryover receives no benefit from the larger deductions. Their rental losses must be offset with future rental income. A real estate investor can avoid this limitation by materially participating in the rental activity and becoming a “real estate professional.” Fear of depreciation recapture is another reason. When an investor sells their rental property, they will have to recapture depreciation deductions at a rate of 25% – so they would rather not accelerate the portion that might be recaptured.
Time Value of Money
Everyone has heard the phrase “a dollar today is worth more than a dollar ten years from now.” So if a dollar paid today is worth more than a dollar paid in the future, why choose to give up the dollar now? The longer you delay paying taxes, the more money you can invest wisely and keep in your pockets. And of course you can avoid the recapture altogether and defer your taxes indefinitely using a 1031 exchange.
According to IRS data, Bob and 78% of all taxpayers in America don’t segment their assets to maximize deductions. Many do not know about the opportunity, some may think it’s too complicated, and others do not see the benefit. Investors should educate themselves on accelerated depreciation, and understand the opportunities that are available to them. A Cost Segregation guide is available on the IRS website. You should discuss the pros and cons with your tax advisor, and make an informed decision.
I know now that the wise man was speaking the truth to me, and I certainly regret missing out on my own depreciation deductions.
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