Depreciation in the simplest of terms is merely the admission that whatever we build on the dirt, and sometimes below, deteriorates over time. Things get old and wear out. Who’d a thunk? The idea is that the real estate investor has put risk capital into improved real estate, an asset that by definition will be subject to breakin’ down. Therefore the Internal Revenue Code (IRC) allows the owner to assign a ‘life’ to these components, with various options as to how.
Without turnin’ this into rocket science, if you own residential income property, except for the land (Yes, Technical Tommie, there are exceptions. Leave us alone.), you’ll divide the value of the investment by 27.5 years. Every year you’ll be able to apply that ‘loss’ (A paper loss, as you haven’t lost a penny.) to the property’s cash flow. If there’s any of that year’s depreciation left, it can then be applied to your job income. The IRS calls that ‘ordinary income’. Tell me that doesn’t come off as condescending.
So, if you paid $250,000, and the market says the land value is $40,000, you’d figure your depreciation like this.
$250,000 – 40,000 = $210,000 depreciable property. 210,000 ÷ 27.5 = 7,636.
If your property cash flowed $5,000/yr., it’d be completely tax sheltered via the $7,636 in depreciation. That would leave an unused balance of around $2,636 which would then be applied to your personal income tax return. Oops, that last sentence is only true if you make less than $100,000 at work. From that point they begin reducing what you can claim against your personal income. Once you reach $150,000 you’re outa luck, as you’re then not allowed to take any depreciation against your ordinary income whatsoever. There’s an exception but my guess is that fewer than 1% of the real estate investor population qualifies for it. I am, proudly, one of them. But that’s another post altogether.
Depreciation Strategy
My experience has taught me that the vast majority of investors, and surprisingly (Sadly?) a large segment of tax preparers don’t realize that plain old vanilla depreciation can also be used to offset both capital gains and depreciation recapture taxes. This allows investors to incorporate the future application of unused depreciation into their Purposeful Plan. It especially comes into play when the taxpayer in question earns in excess of the $150,000 mentioned earlier. Remember, the fact you may be barred by the application of depreciation to your ordinary income, doesn’t mean the depreciation disappears. It simply accumulates, allowing the investor to pull it ‘off the shelf’ at some future point, for their benefit.
Cost Segregation
As it implies, Cost Segregation (CS) is simply the segregation of all the various components used in the construction of your property. For example, the foundation is given a longer life than say, kitchen appliances. The only factoid you’re probably interested in, however, is that typically, CS will generate upward of 2-5 times the annual figure the ‘normal’ so-called straight line method will produce. A most recent example was a client whose duplex could deliver around $10,000 via the normal route, and roughly $25,000 using CS.
A strategy I’ve used often and with solid results is combining the election to use CS, with clients who’re high wage earners — over $150,000/yr in annual ordinary income. In the case mentioned above, if the investor acquired three such properties yielding $25,000/yr apiece, the following scenario would be an option.
Let’s say the cash flow was $7,000/yr per property. That’s $21,000/yr. Each year, assuming the use of the CS method of depreciation, they’d be generating $75,000/yr. They’d be ‘stockpiling’ $54,000/yr in unused depreciation — about $270,000 or so over a five year period. This allows the investor, if they deem it beneficial in context with their particular Plan, sell, then offset up to $270,000 in capital gains taxes and depreciation recapture taxes. In other words, the investor took their profit essentially tax free. Not tax deferred — tax free. Big difference. Boiled down to its essence, the investor would’ve sold for a handsome profit, without payin’ a dime of taxes for anything. I know, cuz I’ve seen me do it for clients over and over. 
Let’s leave it at that for tonight. Suffice to say, depreciation isn’t a dry subject when all the nuances made available by the Internal Revenue Code are known and understood. Then it’s an exciting topic to be sure, especially around April 15th. Make sure to check this with your CPA and/or super duper tax expert — your mileage may vary. I’m not a tax expert. Chuck Perkins is though, and he’ll tell ya that I speak truth.
Meanwhile, back at BawldGuy Ranch, how ’bout a call, eh? I need a fix and you callin’ 619 889-7100 will get it done. You can choose to use the Contact BawldGuy button at the top of the page if you prefer. Have a good one.
Related posts:
- Real Estate Investors – Not Always Advisable to Use Accelerated Depreciation
- Are You Getting the Most out of the Depreciation Available To You?
- Barred From Using Depreciation Against Your Ordinary Income? Consider This
- When Does Depreciation Start? Are You Sure?
- Getting More Out of Your Depreciation When You Need It
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Can you explain the difference in the depreciation recapture tax amount? Wouldn’t the depreciation recapture tax equal the amount of depreciation taken over the 5-year period regardless of whether depreciation was on a “normal” schedule or a CS schedule? Thus, there would be no difference between the depreciation methods at time of sale? That is, depreciation taken over the 5-year period would be completely offset by depreciation recapture at the time of sale using either method?
Anon poses a good question. I’m still trying to completely wrap my head around these concepts. Let’s make some (super simple) assumptions: investor uses accelerated depreciation for 5 years at $10K/year; this depreciation offsets $1k of net rental income leaving $9K/year of unused depreciation which he can’t use to offset his ordinary income because he makes >$150K/year. After 5 years, he has $45k of unused depreciation (5 years x $9k/yr unused depreciation). If he bought the place for $200k, in 5 years it will have a basis of $150k due to the depreciation (once again, very simple example not taking into account other things that make up a property’s basis). If he sells the property after 5 years for $200k, he has a gain of $50k which was entirely due to depreciation taken… so, he has $45k of unused depreciation to offset most of this depreciation recapture. Its seems as if there is likely no way to sell the property without paying SOME taxes due to depreciation recapture/capital gains unless you sold the property for less than you bought it. Am I missing something?
That being said, if my understanding noted above holds true, I still see the tax benefits of depreciation, it just doesn’t appear as great as I had previously thought.
Hey Kyle — There’s a fatal flaw in your scenario, I’m inches from publishing an answer to Anon, which addresses your question exactly, and in rich detail. Stay tuned.
Welcome, Anon — The answer to your excellent question is, yes, no, and kinda sorta. Let’s take a look.
First, you’re correct — recapture is based on applied depreciation. So method used isn’t relevant. Whether you used $1 or $1 million, recapture applies. The difference shows up when the taxpayer is barred by IRC regs from using all the depreciation available. The first main ‘barricade’ to its use is the $25,000 limit when applying it to ordinary income. The other is when the taxpayer earns more than $150,000 in ordinary income, which completely shuts him out from applying depreciation against his ordinary income. Here’s an example scenario.
If your salary at work is $165,000/yr., you’d taken CS for five years ($35,000/yr), and your total cash flow for that period was $30,000, here’s what would happen.
A. You used $30K of the available (CS) $175K depreciation — leaving $145K unused depreciation.
B. You sold at the end of five years. Your capital gain is, say, $100K. You must recapture what depreciation you actually used. In this scenario it’s $30K. (Recapture is actually taxed at higher rate than cap gains. Just so ya know.
)
C. Given this set of facts, you’d have sold, taken the net proceeds, and gone your merry way without any taxes owed — ever. Just did this for a local client not too long ago. But wait, there’s more!
There are other rewards emanating from this strategy.
Cuz you eschewed deferring your gain via exchanging (IRC Section 1031 tax deferred exchange), you’ve become what I’ve often referred to as a ‘reconstituted virgin investor’. In plain English, you’re not encumbered by your last property’s old basis. So, when you take your tax free proceeds, which includes your unconscionable profit (:)), you’ll be acquiring a much higher depreciable basis from which to extract remarkably more annual depreciation than if you’d acquired the same property through exchanging, tax deferred. In some of my client case studies, it’s almost literally been off the charts better.
Another huge perk in avoiding a tax deferred exchange, if possible, is that when/if you do sell in the future, your cap gains liability will be relatively gigantic. Not only that, but I’ve seen, and been brought in as a consultant on many cases where the investor literally didn’t/wouldn’t net enough proceeds to pay the dang cap gains/recapture tax bill. Talk about ruining your day. I’ve had the pleasure of puttin’ the kibosh, over the years, on dozens of proposed exchanges that would’ve financially crippled the investor.
I could go on, but you get the picture, I’m sure. Feel free to ask other questions, Anon. And don’t be a stranger, alright?
Ah, depreciation actually USED gets recaptured– what a novel concept! Thank you for fixing my conceptual error. You made a dry subject interesting and easy to understand.
Jeff, what documentation do you need to have on hand to back-up the cost segmentation strategy, and in your experience, what is the cost of this study/paperwork?
I imagine you can’t just say, xx% of the purchase price should be depreciated over 5 years.
Hey Chris — That’s another excellent question. You’re correct — those who file returns merely claiming numbers for the various components used in the CS method, will no doubt run into questions from you know who.
There is a CostSeg study. Your CPA can do it, as long as they have a serious understanding of CS. The cost is high for 1-4 unit properties if you hire an engineering firm to do it. They’re used to gettin’ low-mid five figures for multi-million dollar properties. I know that Chuck Perkins can do it at a very affordable price, especially if the property’s new. Your point is very well taken, though. It’s hardly worth it if the the study takes all the flavor out of it.
Bottom line? Clients using CS with Chuck as their CPA, will fare very well with the costs.
Let me know if this answered your question, Chris.
Yes it did. Thank you.
The accumulated depreciation can also be used to offset the additional taxes owed on a SEP-IRA to Roth IRA conversion. I know you are not a great fan of IRA’s but in my case I had a lot of depreciation accumulating and not enough income to apply it against. This allowed me to move my funds into a much more flexible vehicle without paying the tax out of pocket.
Welcome, Jeff — I’ve done for a few clients. Thanks for pointing that out. It’s also solid info for a post.
Don’t be a stranger.
Hello, Interesting info! I was wondering if this strategy is relevant for anyone earning less then $150k… not sure if I need to bookmark this page and check back in a few years when I am over the $150k mark
. Thanks!
There are many options/strategies available for those making under that amount — including this specific strategy. It’s just used slightly differently. CS is especially useful.
Another masterpiece from the master. Thanks.