Depreciation
Depreciation: Maximizing the Benefits of Investment Ownership
As an investor, the IRS allows you to depreciate property according to a set schedule. That depreciation deduction will help off-set any net profits or earned income for the year.
When you buy investment property, should you be concerned about depreciation before you actually buy the property? Or is that something your accountant should worry about next tax season? Trust me, you want to worry about it now!
Many accountants will tell their clients that they can simply take X % in depreciation on their building.
BASIC RULE: Land never depreciates!
However, there are four different elements which combine to make up a property as we know it. Land, Building, Land Improvements and Personal Property. To use one rate for all elements could potentially lose you money. According to the IRS, each one of these depreciates at different rates.
- Land – Never depreciates
- Building – Depreciation is taken over 27.5 years for residential buildings and 39 years for non-residential
- Land Improvements – Such as driveways, landscaping, irrigation system, pool, etc, depreciates over 15 years
- Personal Property – Depreciates over 5 years
A standard way of taking depreciation on rental property has been to look at county tax assessors records and take their percentage for land and building. Then, since land never depreciates, take the building value multiplied by the Recovery Percentage for residential property (set forth in the Internal Revenue Code or IRC) and you get the amount of your depreciation
Now we come to the reason I asked you if it was important to understand depreciation BEFORE you purchase the rental property…
If you were to separate, up front, at the time of purchase the amount of money you were paying for each of the 4 elements discussed above, YOU , not the County Tax Office, can set forth the value of each of those elements and the prominence of each as it relates to depreciation. (????, you say?)
Well, here’s a word you should get to know: BIFURCATE. It’s pronounced ‘bi’ as in ‘bi-lingual’, ‘fur’ as in ‘fur coat’… and “cate” as in the name Kate. Makes sense? Bifurcate is the technical word that means to Separate the elements of the property in question.
Take a look at the following side by side comparison using the standard one rate depreciation and the allowable multi-rate depreciation and note the tax savings at the end!
| Standard Method:
Let’s pretend you’ve owned a 4-unit rental building valued at $400,000 for one year. Your accountant told you the depreciation rate on a residential building was over 27.5 years. The County Tax Assessors records indicate that the property breaks down as follows: Land 30% At tax time, here’s what happens: 70% of the property’s value = $280,000 $280,000 multiplied by the IRC* determined recovery rate of 3.48% = $9,744 The result would be $9,744 in depreciation. In a 35% tax bracket, the tax savings would be $3,410.40 * Internal Revenue Code
|
Bifurcated Method:
Let’s say you own the same 4-unit rental building valued at $400,000 for one year. Because you had a smart real estate agent and a good accountant, you bifurcated at the time of initial purchase (in the Purchase and Sale Agreement) and separated the elements of the property as follows: Land 15% Now, at tax time, when you sit down to calculate the depreciation, look what happens: 65% of the property is the building at $260,000 $260,000 muliplied by the IRC* determined recovery rate of 3.48% = $9,048 10% of the property is land improvements at $40,000 $40,000 multiplied by the IRC* determined recovery rate of 5% = $2,000 10% of the property is personal property at $40,000 $40,000 multiplied by the IRC* determined recovery rate of 20% = $8,000 This equals $19,048 in total depreciation taken At a 35% tax bracket, this means $6,666.38 saved in taxes * Internal Revenue Code |
In the above example, you could have saved $3,255.98. There is tremendous missed opportunity out there for a lot of investors. If you are reading this and you find that you too have been missing out on the tax benefits of bifurcating, it’s not too late. According to the IRS, you are allowed to re-do you tax returns up to 3 years back — so you may have some money coming back to you. You never know! Wouldn’t it be in your best interest to find out?
