These regulations keep some of the rules that had been proposed, but have made some significant changes. I’m still digesting the 255 page regulations published in the federal register, and can share some highlights of the changes for now.

The IRS has established some new bright line tests as to whether expenses are to be capitalized or can be expensed. In the past one would look at the extent of improvement to the asset as a whole. Repairing any portion of the roof was considered a repair. Only if 100% of the roof was replaced did it require capitalization. Now the IRS requires businesses and investors to look at the components of an asset. If one were to do a 60% replacement of a roof it would be considered an improvement rather than repairs. Based on my initial read replacing a rotted bathroom floor might still be a repair, but replacing a hot water tank or shower quite likely would require capitalization.

Another important change has to do with component replacement. When an investor remodels a kitchen by replacing cabinets, flooring, countertops, etc, it used to be that the investor would continue to depreciate the old components and capitalize the improvement. Now, an investor can retire (dispose of) the replaced components while capitalizing the new. You might ask how that is going to be accomplished.

Good question — the answer is that any reasonable method is going to be allowed, but how the asset was set up is going play a big part in this.

When it takes 255 pages to clarify and simplify, you know that there are going to be many exceptions and gotchas. I promise to share more over the coming weeks as I better understand these new rules.

BawldGuy Here: Only the government must take over 250 pages to ‘clarify’ and ‘simplify’ an already fairly simple, universally understood concept.

Often times though real estate will be held in an entity such as a trust, partnership or corporation. All of these entities will require a special information return to be filed disclosing information to the IRS about this foreign entity.

Forms, there are forms

Investors also may setup a bank account or investment account in the country where there real estate is located. This may mean that an investor will be required to file two information returns (A form 8938 required in 2012 and an FBAR TD F90-22.1). Not all foreign bank accounts will require an information return but it is important to be aware and file if it is required. Form 8938 requires much of the same information that is on the FBAR but is not subject to the same disclosure requirements.

Penalties can be very significant for not filing these information returns. Not the least of these is the $10,000 fine for failure to report. There are several other penalties as well and they can add up fast.

If you are a US investor with real estate abroad I would strongly recommend seeking a tax professional familiar with these tax regulations. They can also review your foreign entities and financial investments to insure that any and all information returns are filed timely.

I will follow up next time with issues that a foreign investor should consider when investing in US real estate.

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.

Today, it is easy to place too much trust in the tools we have at our disposal. I say this because it is far easier than many might realize to miskey and assume that our software will properly calculate, store and report on the information we put in.

What does this have to do with anything you say? Well, I find that many times people don’t realize a mistake has been made because they don’t have a clue of what the expected outcome should look like.

The Point

I know, I know. Get to the point. The point is income tax law can be quite complicated. Hear me out, I know you might be looking for Captain Obvious as the BawldGuy likes to say. Captain Obvious is close by, but I find that our reliance on software can lead to mistakes big and small.
It is easy for tax preparers and others to think that inputting all of your financial data into a program like TurboTax and carefully answering all of the questions will lead to a tax return that is correctly stated and report the least that should be paid to the IRS.

When returns get complicated

When taxpayers are strictly employees and have but a few deductions, then tax returns are pretty straight forward. It is when individuals get into businesses and investing activities that returns can become complicated. Real estate investors can have some very complicated returns.

One aspect far more complicated than some might realize is how gains and losses in real estate are netted and interact with gains and losses of other investment activities. There can be loss carry forwards, lookback rules, at risk limitations and differing treatments for similar property classed under different IRS code sections.

Tax software can make some of these things seem deceptively easy. Knowing that the various transactions have been treated properly is often the real problem. It is all about recognizing that the answer given resembles something that makes sense and recognizing when something is clearly not right.

While I hear some of you saying to yourself “Garbage in, garbage out,” it really isn’t that simple. You can have good information that is incomplete or mislabeled. Recognizing what the outcome should look like helps.

I was reminded about the complexities of the tax code as I helped a student this week review capital gains rules. It is not that most investors can’t find the answers. Instead, it is much like BawldGuy often laments — you can’t find answers to questions you do not even know to ask. For example, re: capital gains, what’s the adjusted basis? Is there any loan over basis? (A very important question when executing a tax deferred exchange.) Are there any losses you might be able to use in offsetting any gain? What schedule/strategy was used for depreciation? And on and on and on.

Knowing what your answer(s) should look like gives you an incredible edge over most who’re using software to get the job done. Garbage in, garbage out is bad enough. But when the taxpayer is literally unaware of data/answers they should be inputting, but can’t, therein lies the real reason so many out there aren’t getting what they think they paid for.

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.

Some might advocate doing what can be done each year to lower taxes. In my opinion it is often better to look at the current year and review what you expect in the coming year. In this way it is possible to hasten or postpone expenses to minimize taxes in each year. Life changes may create substantially more income or expenses in one year and doing what you can to time other income or expenses can help moderate the impact of these life changes.

There are many examples of expenses that can be hastened or delayed. For instance repairs can often wait for a little while or proceed ahead of schedule. An investor might decide to delay or move up the closing of an asset purchase. Even if an asset is purchased it might be beneficial to consider waiting to put the asset in service. Other expenses such as advertising, professional fees, tools, supplies, cleaning costs might be timed.

While timing income and expenses can be a great strategy — avoid going over the line.

It is an unwise, unethical and illegal strategy to manipulate income and expense dates in an accounting system. While someone might not get caught right away if an audit does happen and evidence is found that fraud occurred the IRS is given a key to open up many additional years for review. Normally there is a 3 year window, but with fraud there is no statute of limitations and the penalties can get quite harsh and are not deductible.

Constructive Receipt

Another consideration for income received is the constructive receipt rule. If a tenant delivers a check for rent on Dec 31st but you wait to deposit it until January 2nd. The IRS will say that it was constructively received on Dec 31st and must be included in that year’s income. Now if a check was received on that date and it turns out to be NSF when deposited on Jan 2nd, no cash is considered to have been received.

No Constructive payment doctrine

Writing a check on Dec 30th and mailing it on January 2nd is not considered a Dec 30th payment regardless of the date you put on the check. It might go unnoticed if it is only a day or two different. Be wary though when a track record is found of checks mailed out that take weeks to clear the bank. If an audit occurs it is standard procedure to test any transactions that occurred near the year end and at the beginning of a new year.

In short, there are legitimate ways to time income and expense items without resorting to fraud or tax evasion.

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.

There are a number of ways real estate can create current income. The best examples would be through wholesaling and flipping. In this post, I want to look at rental property which can be selected to emphasize income or capital growth.

Rental property has four ways to create wealth or income.

• Cash flow
• Appreciation
• Equity buildup
• Tax savings

An investor can attempt to maximize one or more of these aspects of real estate. For those wanting to create the most current income would emphasize cash flow. An investor looking for capital growth might emphasize appreciation and/or equity buildup when selecting a property.
Regardless of your investment strategy, tax planning is an important consideration that needs to be planned for as well. Your Purposeful Plan should take advantage of tax strategies that minimize taxes during the investment period.

There are many choices you, as an a real estate investor make during the year that can have varying effects on your tax situation.

• How active you want to be in managing properties
• Financing decisions and choices
• Timing of income and expenses
• How security deposits are handled
• Use of a home office or storage area
• How property is sold
• Hiring contractors or employees
• How personal property will be depreciated
• How to take title to a property
• How to handle easements and encroachments
• When or if to do a 1031 exchange
• Should an installment sale be considered
• How seller financing might affect the transaction
• How to handle casualty losses or thefts
• Regularity of buying and selling properties
• Flipping some properties and renting

There are more considerations but this gives you an idea.

The choices you make can improve your current income picture or assist in capital growth. One needs to remember that capital growth is far more than property appreciation. Every payment made on a property builds equity. Many investors will have a loss carry forward that can be used to reduce future capital gains and depreciation recapture which aids in capital growth.

BawldGuy Here: Don’t let that last sentence get past you. I’ve written a post that should be published Tuesday on BiggerPockets that will, in rich detail, address how using multiple strategies synergistically can work to create stellar results. One of the strategies I’ll be talking about involves the concept of ‘loss carry forward’.

In short waiting until tax time to do your tax planning is a sure way of limiting your choices and will lead to less than optimal investment results. Every investor’s situation is different and for some, tax planning will be less necessary, while for others it can make huge differences.

Good tax planning though starts with having an investment plan and looking at your whole situation so that each transaction can produce the maximum benefit for your current and future investment situation.

“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.