In the last several years the IRS has been attempting to clarify and bring these various code sections back together. Several times they have issued proposed regulations. In December 2011 they finally issued temporary regulations that were supposed to fix many of these loopholes.

I believe that many investors will be surprised by what is in the new regulations. For one, investors will need to understand what the major components of a building are and track the extent of repairs to a major component. It will also be necessary to estimate the cost of a component that has been replaced.

You might ask, what does all of this mean in plain English and how does it impact your investments?

In the past an investor could replace nearly the entire roof of a building and it would be considered a repair. The new regulations see this differently. The roof would certainly be considered a major component of the building and so fixing and repairing 51% of the roof quite likely would need to be treated as a capital improvement. It will be necessary for investors to understand what the IRS might consider a major component. An example that I would clearly have expensed in the past might be adding a second layer of roofing over much or perhaps the entire roof.

Sea of gray?

The rules now allow for the disposal of a component of the building when it is replaced. This is going to be a challenging exercise for some. For those that have cost segregations it will be fairly easy to estimate the value of components that are disposed of. For the vast majority of investors in residential investment property this is going to be a quite tricky gray area. An investor who has all of the galvanized pipes in a home replaced is going to need to estimate the value of that component and capitalize the cost of the plumbing.
Some scenarios may actually not allow any disposal. A home that had little or no insulation might be such a situation. The new insulation would certainly need to be capitalized now, but if the home was purchased with no insulation it would not be possible to dispose of that component.

For those who can’t sleep here is some light reading on the new regulations:

http://www.journalofaccountancy.com/Web/20125301

You can also read Rev Procedure 2012-19 and 2012-20.

As the tax season winds down I will be spending more time reviewing these new regulations, some new case law on cost segregation, and a host of other issues. As some of this information gels in my mind I will share it and help you make some sense of it. There has been a surprising number of rules, proposals, cases, regulations passed that impact investors and I will help shed some light on how these impact you.

Now for some real estate investment info to dazzle ya.

Charles Perkins is workin’ on some killer posts, some of which were by my request. ‘Course, I’ve learned to keep my topic suggestions with him as narrowly defined as possible. He tends to research the livin’ crud out of it, which makes me feel guilty sometimes. This is especially true the last month of the year — which, unfortunately is merely the precursor to ‘tax season’. For CPAs, tax season is that ugly stretch of roughly 105 days, when they sleep at least 3-5 hours a day, no matter what.

• He’s got some killer info on various aspects of depreciation.
• He’ll be listing some of the brand new surprises the IRS has for us — most if not all of which went into effect last Sunday.
• I’m makin’ a topic list for him. (Hope he doesn’t read this.)

John Park will be providing his usual stellar posts on self-directed IRAs/401Ks. The guy is always comin’ up with solid info. The clients who’ve used him, now swear by him. He’s the real deal.

David Shafer is by far the most knowledgeable pro I’ve ever met, when it comes to EIULs. He’s a wizard when it comes to EIUL structuring, which is the most crucial factor. I’m big time OldSchool, but Dave sometimes makes even me roll my eyes.

My first post this year will be on the topic of tax deferred exchanges. In fact, I may do a series on all the different strategies for which it can be incorporated into a well thought out Purposeful Plan.

Meanwhile, back at BawldGuy Ranch, operators are waiting to hear from you. Seriously, I need a fix. Call me at 619 889-7100 — OR — click the Contact BawldGuy button up top and gimme your story. I wanna hear it. Have a good one.

Here’re Dave’s questions, verbatim, with text before and after, edited out. You can still see his comment in its entirety by going to the link above.

Let’s assume one buys a $250,000 home in Austin. He puts down 20% and gets a 30 year loan at 4.62% for $200,000. He rents it out for $1375/month. He has plenty of cash stored away in case of an emergecny. Here is how my numbers would look:

mortgage=$1,025/month
insurance=$45/month
taxes=$100/month
maintenance=$100/month
property manager=$108/month (8% of 1 month’s rent)

TOTAL=$1378

Basically, it would be a breakeven. So, what you are really saying is that it is perfectly OK to not cash flow. As long as one buys in the right location and has the right time frame, then the plan would still work out over the long run. Is that correct? Are my numbers somehwat close to being correct for buying a nice home in a good area in Texas?

Where do I begin?

I’ll take most of the blame for this one. You’re foundational assumption is inaccurate — the property of which I was speaking wasn’t a house. It was a duplex. The rent wouldn’t be $1,375/mo. It’d be anywhere in the range of $1,225-1,3550/mo per side. So, if you used a recent, real life example, it’d look something like this.

Paid $255,000 — rented $1,350/side — $2,600/mo — $31,200/yr, gross rent. Expenses would run in the neighborhood of $11-12,000. This would include everything. My clients only pay 5% management fee.

Let’s say the Net Operating Income (NOI) is around $19,500 or so. At 5% interest your monthly/yearly debt service, at 75% LTV, would be $1,026.67/12,320. You can readily see there is some decent cash flow there. Again, I take responsibility for you thinkin’ it was a house, and not a duplex.

But you ask a great question, Dave. Is break even OK? Well, yes, and no.

In today’s investment climate, I’d be far less inclined to advise clients to accept a break even property. On the other hand, the key question would have to be — What would the specific circumstances be? In past eras I’ve literally begged a few, select clients to purposefully buy multiple properties with a combined negative cash flow that’d make your head spin. But those were way different times than we have today — and that’s an understatement if there ever was one.

BawldGuy Axiom: The real estate investment strategies applied for a particular investor must be selected with an intimate knowledge of the economic climate, IRS rules/regs, and the general/specific investment context of the times. A Purposeful Plan using multiple strategies synergistically, is only effective when they’re all applied in the correct context. For instance, a strategy with appreciation as a crucial factor in today’s investment reality would be, um, ill advised. (Captain Obvious alert!)

Back to our regularly scheduled program.

Investors in those days could depreciate property twice as quickly. There were NO limits on how much depreciation they could apply to their ordinary (job) income. There were NO limits to how much they could make in ordinary income in order to make use of depreciation. Those two factors aren’t in play today — period.

Combine those facts with the reality of the cartoonish appreciation of that time. (Mid-late 1980s.) Back when I was tellin’ a very few select clients to purposefully acquire relatively large negative cash flows, their properties were goin’ up in value 8-15% a year, year after year. Even applying the bottom of that range for five years on a half million dollars of property — roughly $1.5-2 Million in today’s San Diego values — they’d see their property values balloon by nearly 50%. At 10% a year, their $500K in property would rise to about $805K, a 61% increase in five short years.

But that didn’t tell the real story, at least not from the investor’s point of view.

What I didn’t tell you earlier, is that in those cases my clients were easily able to buy properties with just 10% down payments! That means that in five years, heck, just three years, at 8% annual appreciation, their $50K beginning equity position was improved to roughly $180K! Put another way, their invested capital, (I’ll use $60K to account for acquisition closing costs.) was literally tripled in just three years.

Their negative cash flow? Completely eliminated in two very concrete ways.

1. Their income taxes were drastically reduced, in many cases by nearly 90%. In essence, they had merely traded income tax dollars for short term negative cash flow dollars. Quoting one of those clients, “Where do I sign up?!”

2. In an inflationary economic environment, rents tend to float up with the rising prices at the grocery store. This tends to add velocity to the elimination of negative cash flow. Go figure. (See? Give Captain Obvious an inch, and he takes a mile.)

BawldGuy Takeaway: No real estate investment strategy can ever be implemented effectively sans the context of the current economic realties, IRS rules ‘n regs, and the investor’s specific financial status quo. Without knowing those factors in rich detail, you might as well blindfold yourself and throw darts at a list of investments, locations, and strategies.

Sadly, that’s almost what so many seem to be doing the last several years. Strategies don’t exist in a vacuum. Economic realities are ever changing. What was a great market in which to invest a decade ago, is now a graveyard for investment capital and retirement dreams.

Thanks again, Dave, for your kind words and excellent questions.

Call me with your questions! I need a fix, and I need it now. My number is 619 889-7100. Your other option is to click the Contact BawldGuy button up top, and write me. Have a good one.

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.

Passive Activity Loss rules and At Risk limits were created to dissuade investors from using these limited partnerships. The feeling was they lacked economic substance — in other words they were not created to make a profit.

I think most investors are aware of what the Passive Activity Loss rules are, but these days many seem unaware of how the At Risk limit can impact any real estate losses in a given year.

Passive Activity Loss rules refresher:

Passive Activity Loss rules have to do with an investor’s level of participation in their investment activities. An investor who is not actively involved is not allowed to take any losses in a given year. An investor who is considered active can deduct up to $25,000 in losses, but will have this reduced by 50% for every dollar of AGI exceeding $100,000. Clearly then an investor with AGI of $150,000 is unable to take any passive loss in a given year.

A few investors may also rise to the level of material participation. These investors would be considered Real Estate Professionals as defined in the tax code. Few investors spend enough time in real estate to be considered Real Estate Professionals and I’ll leave this topic for another post.

At Risk Limit

The At Risk limit is based on the amounts an investor has invested in a RE property. It also deals with loss limits that might be contractually created. Limited partnerships were created to limit the liability of the limited partners. These at risk rules specifically limit any loss to the amounts contributed or loaned to a partnership adjusted by each year’s gains or losses.

While limited partnerships are little used these days, there are still ways that some investors use to limit their losses. The use of nonrecourse loans (financing secured only by real estate), stop gap agreements, loan guarantees and other agreements.

How do these rules limit loss recognition?

The At Risk limit must be considered first. If the loss for the year exceeds the partner’s basis in the property, then the loss must be limited to the amount of the basis. Under some circumstances losses can be subject to At Risk recapture.

The Passive Activity Loss rules then apply to the loss amount as set by the At Risk limit.

Parting Thoughts

Investors seeking knowledgeable professionals can quite easily avoid some of the pitfalls of the At Risk limits. There are many ways to limit risk when investing without creating additional taxable income.

Anywho, I wrote about an ongoing case study over there this morning. It’s about combining several strategies dynamically to improve your end game results, which is spelled — Retirement Income.

BawldGuy Heads Up: Tomorrow (Wednesday) I’ll be out of touch with the world completely. Gettin’ some dental work done, and they wanna knock me out to do it. Works for me.

I’ll be available for calls beginning at noon Thursday. ‘Course by then I’ll be Jonesin’ for a fix. You can help me with that by callin’ me at 619 889-7100. Or you can, if you prefer, send me a note using the Contact BawldGuy button up top. Have a good one.

“When you say the ‘after tax’ cash flow is $X, what gets taxed, and is it like my paycheck’s ‘after tax’ sadness?”

Well, sometimes it’s the same. For many however, the after tax cash flow is actually greater than the before tax cash flow.

How can this happen?

Paradoxically, when your after tax cash flow is higher, it’s due, the vast majority of the time, to a loss. It’s a paper loss to be sure, but a loss nonetheless. In this case it’s what’s called ‘depreciation’. Simply put, depreciation is the IRS agreeing that buildings and many of the things inside them, even things appurtenant to the land, ‘depreciate’ in value over time. In other words, they wear out.

Thing is, you don’t really experience a financial loss, it’s only on paper. When you file your tax return your tax preparer will include a figure for depreciation. It’ll be on Schedule E. Again, it’s only a paper loss — you didn’t lose a nickel.

However, since your cash flow was say, $9,000 and your depreciation was $29,000, the cash flow itself isn’t taxed. It appears as if you had no cash flow on the return — in fact, you lost money. But not really.

But wait, there’s more! What happens to the extra $20,000 of depreciation?

So glad you asked. That amount, as long as your ordinary income is $110,000 or less, can be applied as a loss against that income. By the way, ordinary income = job income in IRS-speak. I say $110,000 or less cuz the IRS begins phasing out the real estate investor’s ability to make use of depreciation ($25,000 max a year against personal income.) once their ordinary income edges over $100,000. Once you reach $150,000 you’re outa luck Chuck. No depreciation can be used against your ordinary income. (Don’t ask, it’s a whole nuther post. ) So if you had $20,000 in applicable income and made no more than $110,000 at work, you’re probably good to go.

BawldGuy Caveat: Look, been doin’ this for decades and know what I’m talkin’ about. But seriously? Don’t believe me, believe your own qualified tax preparer. Better yet? Give very experienced CPA, Charles Perkins a call and tell him I sent ya.

What that means in language you and I speak, is that if your income was $76,000 that year, the $20,000 depreciation ‘loss’ now magically makes it $56,000 before you even start fillin’ out the return. In terms of your taxes, here’s the payoff. Counting Fed/State taxes, and oversimplifying things, if your combined marginal personal tax rate (state & fed) is 25% — you just saved $5,000 in taxes.

Here’s Before — Here’s After

So your before tax cash flow is $9,000. But your after tax cash flow, due to the $20,000 ‘loss’ applied to your job income, is now $14,000.

$9,000 in actual cash flow + $5,000 tax savings = $14,000 in after tax cash flow.

And now ya know. Make sense?

Know what really makes sense? Givin’ me a call at 619 889-7100 to talk about what our retirement is gonna look like. Is it lookin’ as good as it should so far? No? Helllo? Dial. Or send me a not via the Contact BawldGuy button up top. Have a good one.

I suspect though that many investors have no idea just how much depreciation can be taken in the early years of a property’s life. Spreading depreciation out over 27.5 years does help the bottom line, but if it was possible to spread a lot of that depreciation over a 5 year period I think you can see how that might prove to be a far better tax benefit.

Recently I talked about land improvements which are depreciable though land clearly is not. I gave you a taste of what can be carved out as a 15 year land improvement. Clearly, depreciating an asset over 15 years is better than 27.5 years. If you didn’t read the post you might want to take some time to read it.

I suspect though that many investors might be surprised at what can be classified as 5 year property. Revenue Procedure 87-56 is what is commonly used to classify assets and determine their tax life. Common 5 year property listed in tax returns I see would include appliances, blinds, drapes and perhaps carpeting. As an investor it may not seem worthwhile to take much effort to break these items out and I would agree.

There is much more than can be classified as 5 year property. Some key areas include special purpose plumbing and special purpose electrical. There is important case law that set precedents allowing these items to be treated as 5 year property.

A very important tax case, Hospital Corp of America v. Commissioner in 1997 clarified an earlier ruling that stated electrical wiring, plumbing and such connected to personal property was not part of the electrical or plumbing system but was part of the personal asset. This is a huge tax distinction.

In other words the wiring that connects a range to a circuit breaker is 5 year property not 27.5 year property.

Exterior site lighting and the electrical wiring necessary to make them work is also 5 year property. It is Reg Section 1.1245-3(b) that defines this lighting as tangible personal property.

Decorative lighting is also tangible personal property. Metro National Corp v. Commissioner is the case used to support this classification.

These are a few of the cases and regulations used in breaking out a substantial amount of 5 year property. In order to do this properly though a cost segregation study needs to be done. Often cost segregation studies can be quite costly — but they don’t have to be.

Reading through this list should give you a much greater appreciation for just how much more depreciation can be take in the first 5 years of a property’s life. There is more, but this is much more than I think most of you realized.

BawldGuy Here: With this post and Chuck’s linked post now in the can, I can write a post next week about how to use this info strategically. There is a ton of potential synergy available when used with other investment strategies. I think you’ll find it as surprising and fascinating as I have. There are some real solid gold opportunities here.

What many might not be aware of though, is that land improvements are deductible. There are many improvements that we make to land. Some of which you might not think of generally as improvements.

Why take the time to make this distinction?

I think many investors leave some depreciation on the table. It is a common practice among tax preparers to use the assessor’s break out of improvements and land as the ratio when determining what is depreciable. I’m going to tell you this might be a starting point but it is a sure fire way to lose potential deductions without at least some adjustments for land improvements.

When you think about it, it’s quite clear that improved land has much more value than raw land. Many improvements would require a cost segregation study, but some improvements can more easily be broken out.

What are these land improvements?

There are actually many things we do to improve the land. Some improvements are simply to increase curb appeal or the attractiveness of the land. For example — think landscaping, shrubs, pools, walkways, patios, etc. Some improvements may be made to improve security such as outdoor lighting and fencing. Some improvements may be more for preventing erosion such as drainage systems, retaining walls or special plantings.

My purpose here is to get your mental juices flowing. An income property is more than a house on a piece of land. An investor looking to increase their cash flow and perhaps reduce their taxes would be wise to look beyond the obvious. Some of the land improvements can be broken out simply and justifiably. To really take advantage of all your potential depreciation it is wise to look into cost segregation. Many may realize how a cost segregation study might help with depreciating some of the components of a building faster, but it is my belief and experience that many investors fail to consider that land is more than dirt.

BawldGuy Here: For awhile now I’ve been outlining a post I hope to publish next week about using multiple strategies synergistically, including cost segregation. It’s relatively involved, so it’s takin’ awhile.

The easiest way to understand this concept is to go through a couple of examples.

EXAMPLE 1:

An investor finds a duplex and prepares a purchase sale agreement on Jan
3. He closes on the property Feb 16. The property was vacant in January and remains vacant in February. After closing on the property the investor immediately starts work on some renovations. Turns out there were a number of hidden problems and the renovations are not completed until June 15. In anticipation of completing the repair work the investor started listing the property for rent on Jun 1st. Unfortunately it took a couple of months to find good tenants and they move in Aug 1st. What date can be used as the In Service date?

EXAMPLE 2:

Same situation as above only the property has existing tenants that decide to stay after the investor closes on the deal. The property needs some repairs though and the investor starts what he can while the tenants are living there. Discovering how extensive the repairs are he finds it necessary to ask the tenants to leave while he completes the work. He manages to complete the work on Jun 15 but the tenants have found other arrangements and the investor starts advertising July 1st. He manages to get tenants in the units on Aug 1st.

A look at each example:

The earliest possible time for a property to be placed in service is on the day you can claim legal title. In both examples that would be the closing date, Feb 16th. In example 1 though the property is vacant and remains so until Aug 1st. To be considered In Service there must be some rental activity. Unfortunately getting a property ready for use doesn’t qualify. Advertising that the property is for rent does qualify though. In Example 1 the investor could start depreciating the property on June 1st.

Example 2 is different.

The units are occupied on Feb 16th. In this situation the property would be considered in service on Feb 16th. Understanding what is meant by In Service allows you as an investor some flexibility in structuring your purchases. You can greatly improve your tax deduction for that first year simply by changing the timing of events. If the investor in example 1 advertised one unit for rent on Feb 16th the In Service date would have been Feb 16th.