Seven Proven Depreciation Strategies

Seven Proven Depreciation Strategies

By Diane Kennedy, CPA

Why do you want to invest in real estate? There are three main benefits to real estate investing:

(1) Cash flow,

(2) Appreciation, and

(3) Tax benefits.

When it comes to depreciation, the topic of this Home Study Course, the focus is on tax benefits. Before we move on to that, though, I would like to caution you on one thing.

It can be tempting to just buy any real estate because of the thought that the tax benefits would make up for any poor decision making in the real estate investment.

Don’t do it.

First and foremost, real estate investment should be about cash flow. If you don’t have cash flow, you better have a pile of money and a long term safe and secure source of cash. Otherwise, you are just betting that you can hang on to the property until someone who will buy it from you. And remember it’s a property that doesn’t cash flow. So, the person who will buy it will be someone who doesn’t care about cash flow. If it’s not their house or their hobby, it means they are an investor who doesn’t care about cash flow. There aren’t many of those.

In real estate terms, that kind of strategy is called the ‘greater fool strategy.’ You are betting you can find an investor who cares less about cash flow then you do.

That’s not a plan for long term success.
Or, you could fall into the ‘rising tide strategy.’ This is a strategy that can come back and bite you too. In this case, the idea is that real estate values are going up, up, up and no matter what you have to jump in now before the market gets out of reach. Everything is fine until it isn’t. Then suddenly you’re stuck with a property whose rent doesn’t cover the expenses and that is worth less than the debt.

Appreciation is nice, especially if it’s planned appreciation and you are going to sell. Otherwise, it should be all about the cash flow.

The third benefit, tax, is what this Home Study Course is about. And, more on point, we’re going to talk about depreciation. The unique tax benefit available to real estate is depreciation. It’s a phantom expense. Unlike a business, you can take a deduction without actually outlaying cash. And you can plan exactly how and when you want to take that deduction. There is nothing else quite like it in the tax world.

This is how the rich use real estate to build assets, create cash flow and pay a whole lot less in tax.

Three Types of Real Estate Expenses

For tax purposes, there are three types of real estate expenses:

Direct Expenses,

Indirect Expenses, and

Phantom Expenses.

Direct Expenses

A direct expense is an expense that is directly related to the property. It would include mortgage interest, property tax, real estate tax, repairs and other expenses that wouldn’t exist if you didn’t have this rental property.

One tricky part with direct expenses has to do with the question of whether an expense is a repair or improvement. This has been a tax issue for years and the IRS finally addressed it with regulations in 2014. Instead of making it easier, though, it was made a whole lot harder.

In general, if you buy something, repair something or improve and the total invoice is under $2,500, you can take an expense for the repair. Otherwise, certain things must be capitalized and then depreciated.

The items that must be capitalized are:

Improvements. You must capitalize any expenses you pay to improve your rental property. An expense is for an improvement if it results in a betterment to your property, restores your property, or adapts your property to a new or different use.

Betterments. Expenses that may result in a betterment to your property include expenses for fixing a pre-existing defect or condition, enlarging or expanding your property, or increasing the capacity, strength or quality of your property.

Restoration. Expenses that may be for restoration include expenses for replacing substantial structural part of your property, repairing damage to your property after you properly adjusted the basis of your property as a result of a casualty loss, or rebuilding your property to a like-new condition.

Adaptation. Expenses that may be for adaptation include expenses for altering your property to a use that is not consistent with the intended ordinary use of your property when you began renting the property.

You usually don’t have a choice turning an expense that should be capitalized into a current expense, but you do have a choice on whether your otherwise depreciable repair expense should be capitalized. There could actually be a strategy here. That’s because the capitalized item would be depreciated. And depreciation gives us strategies.

With the exception of the repair vs improvement possible strategies, you should always report all of your direct expenses. This is true even if the direct expenses push you into a loss that ends up being suspended.

A suspended loss is better than no loss. Report all of your direct expenses.

Indirect Expenses

Your indirect expenses are legitimate expenses that are deductible but aren’t directly attributable to a property. Some examples of indirect expenses could be:

Accounting

Cell phone charges

Computer

ISP

Software, and

Travel.

Just like with direct expenses, I recommend that you always report all of your available direct and indirect expenses, even if you can’t currently take the deduction against your other income. At the least, they will create a loss that can be suspended for later use.

The one possible challenge with indirect expenses will be with expenses that really can’t be reasonably linked to an active real estate business. For example, sometimes I meet people who have spent thousands, even tens of thousands of dollars, on real estate coaching or mentorship. Is it deductible?

Maybe.

If you pay for education to get you ready for a new trade or business, the cost is not deductible. If you already have a trade or business, education may be deductible. In that case, you need to prove that you really are in business already and that the education is going to help you in that business.

Let’s say you have several properties and you attend a class on landlord law to help you know what tenant rights are. You’ve got a deductible expense.

However, if you haven’t bought a property yet and you attend classes to teach you how to find properties, how to find tenants, how to manage and a dozen other things, you probably don’t have a deduction.

You must be in business first.
A client of mine faced an IRS challenge when he took expensive personal development classes and attempted to deduct those against his real estate properties. Unfortunately, he handled the initial meetings himself and made some statements that were later used against him. This was a case more of audit strategy then whether there was a legitimate expense or not. Most of the time, personal development is considered a deduction against a legitimate business provided it can be shown that this will make you a better leader for your business.

Phantom Expense

Phantom expense, depreciation, is different. That’s because unlike the case for direct or indirect expenses, where it’s use it or lose it situation in the current year. If you can’t take advantage of the loss in the current year, you can carry it forward until there is passive income to offset it or you sell the property. But if you don’t report direct or indirect expenses in the year they are incurred, you can’t “catch them up” in subsequent years. You may be able to amend a previous tax return, but that costs you money, time and increases your audit risk.

In the case of phantom expenses, you can catch up past depreciation. You can ignore it. You can accelerate it. It’s available when you need it. And that’s why out of the 3 types of real estate expenses, depreciation, or phantom expense, is the one that you can be strategic with.

Step One: How Much Depreciation Do You Need?

Since we have a number of options when it comes to how much depreciation you can take, the first step is to determine how much you need.

What is your current net passive income/ (loss) less direct and indirect expenses? ______

What is your total net carry forward passive loss? ______

If the total is passive income, note total here: (a)______

If the total passive equals a loss, note here: (b)______

If total is income, you should continue to determine the amount of depreciation to take in the current year.

If the total equals a loss, will you be able to take

a deduction against other income? Y/N

Read the next section “Deductibility” to

find the answer to this question.

Deductibility

If your adjusted gross income (AGI) is under $100,000, you can take up to $25,000 of real estate losses against your other income as long as you have active participation. You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions or arranged for others to provide services (such as repairs) in a significant and bona fide sense.

Management decisions that may count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions. If you are married, you must file as married filing jointly in order to take advantage of that status.

A time share does not qualify and neither does ownership in a limited partnership when you are only a limited partner.

If your adjusted gross income is over $150,000, you cannot take any deduction unless you or your spouse qualifies as a real estate professional. The real estate professional (REP) status can be a little complicated. That’s why there is an entire Home Study Course devoted to this topic.

If your adjusted gross income is between $100,000 and $150,000, the amount you can deduct phases out.

Step Two Determine Current Ideal Depreciation

After calculating the estimated income or loss from your real estate investments after direct and indirect expenses, you then looked at what it takes to take a current deduction of the loss against other income (if you have a loss).

If you can take the deduction of real estate loss or you have real estate income, then the next step is to look at depreciation strategies.

If you already have a loss you can’t take, then the best strategy is probably to not take any depreciation.

Allowed or Allowable Depreciation

Before we move on to the rest of the depreciation strategies, I want to address a lingering myth about depreciation.

The IRS code actually says that when you sell your property, you must recapture depreciation that is allowed or allowable. That one phrase “allowed or allowable” created all kinds of heartburn for CPAs for years. The reading of the code made it seem that if you didn’t take a depreciation deduction, then the IRS was going to force you to recapture depreciation you could have taken, even if you didn’t.

The IRS set that all straight in 2004, over 10 years ago.

The IRS issued Rev. Proc. 2004-11 which permits a taxpayer to make this change even after the disposition of the depreciable property.

Revenue Procedure 2004-11 allows a taxpayer to change the taxpayer's method of determining depreciation for a depreciable or amortizable asset after its disposition if the taxpayer did not take into account any depreciation allowance, or did take into account some depreciation but less than the depreciation allowable, for the asset in computing taxable income in the year of disposition or in prior taxable years. Because the taxpayer is permitted to claim the allowable depreciation not taken into account for this asset, the taxpayer's lifetime income is not permanently affected by the "allowed or allowable" rule.

In other words, Rev. Proc. 2004-11 allows the taxpayer to deduct the unclaimed depreciation even after disposition. With this, the IRS effectively did away with the “allowable” depreciation rule. As a result, a taxpayer who has claimed less than the depreciation allowable for its property will no longer risk permanently losing an allowable depreciation deduction.

Bottom line, if anyone tells you that you must take a depreciation deduction because of an allowed or allowable depreciation rule, just tell them they are over 10 years late to the party.

Depreciation Strategies

High Income, Real Estate Loss Client

A client of mine asked what to do about their real estate. They were following all the rules, they though. They had bought real estate that looked like it would eventually go up in value but because they lived in an area that had high prices it didn’t cash flow.

They still wanted to hang on to it, though, so what could they do to take the deduction?

Answer: If they had a loss after just taking the direct and indirect expenses as deductions, then they should not take depreciation deductions. That’s step one.

In general, though, they need to look at their criteria for buying investments. They need cash flow and they need passive income. Maybe it’s time to sell one of the real estate dogs to free up money and credit to invest in properties that do actually put money in their pocket.

Often people who fall into this trap buy property for emotional, and not financial, reasons. If you want a second house, and can afford it, then buy it. Don’t try to pretend it’s an investment. If you want to buy a special house for your kids, then buy it. But don’t try to make it an investment.

Often the best real estate investment is NOT a house that is your dream house. That is unless your dream is to have investments that provide cash flow so you can live a life free from the financial constraints of a job.

Lesson: Know your numbers. If an investment isn’t cash flowing, don’t make it worse by adding in depreciation. But, you probably also need to think about what are you going to do about these investments. Is it time to dump the bad real estate investment?

Right Strategy, Wrong Year

The first conversation I had with Dr. Greene went a little wrong. He was single and knew that he’d never qualify as a real estate professional. But he was excited to tell me that he was retiring the next year and would then be able to qualify.

He was also excited to tell me that he had read in one of my home study courses about the use of a cost segregation study. He had paid his CPA to learn how to do one and after paying almost $1,000 for the study, he accelerated and used catch up depreciation to create a depreciation expense. Of course, his income was high and he wasn’t a real estate professional, so the whole created loss was suspended. It was not deductible.

And that’s when I told him that he’d made a big mistake.

You see, the loss was now suspended until he either sold the property or had real estate income to offset it. Instead, if he had done that in the year he retired, he could have created a real estate loss that could be used to offset his other income. If his adjusted gross income (AGI) dropped below $100,000, up to $25,000 of suspended loss could be taken in addition to other losses.

He had the right strategy, but at the wrong time.

That’s why it is so important to first know how much loss you can use against your other income. Unlike direct and indirect expenses, you can later catch up depreciation if you didn’t take it. There is no ‘use it or lose it’ rule with depreciation.

Lesson: The smartest strategy in the world might not be right for you, or at least not right now. Make sure you are working with someone to create a strategy first and then put it in place.

Real Estate Losses, Now What?

If you have real estate losses that aren’t deductible, now what?

Step One: Don’t take depreciation deduction.

If you still have real estate losses, you will then have suspended losses. Your question then is, “How can you take advantage of and use up suspended losses?”

How Can You Use Up Suspended Losses?

What do you do if you already have suspended losses?

First, stop or slow down the bleeding. Stop taking depreciation.

Step One: Is it time to dump the property?

There could be a lot of reasons to hang on to properties that cost you cash flow. Most of those reasons are emotional and if you can afford to spend your money that way, maybe that makes sense. Personally, I want my real estate to work for me, not the other way around.

But there could be a financial reason to hang on. It may cost you money you don’t have to sell the property. In that case, hanging on to the property might be the only option unless you are considering bankruptcy.
You could also believe that the value will go up on the property and want to hang on until then to sell.