There Are Three Main Benefits to Real Estate Investing

Real Estate Coaching 6/3/15

Seven Proven Depreciation Strategies

There are three main benefits to real estate investing:

(1) Cash flow,

(2) Appreciation, and

(3) Tax benefits.

Today, we’re going to talk more about tax benefits. In the last session, we talked about the different types of deductions you can take with your real estate: direct, indirect and phantom 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.

Phantom expense, depreciation, is another thing. That’s because in the case of direct or indirect expenses, it’s use it or lose it. 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.

In the case of phantom expenses, you can catch up past depreciation or just ignore it completely. You can accelerate it and front end load it. It’s available when you need it. Today we’re going to talk about 7 depreciation strategies.

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 carryforward passive

loss?______

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

If the total 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

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. We devoted a previous real estate coaching class to the real estate professional question. For more information, go back and look at the April 3, 2015 real estate homework and listen to the recording that goes along with it.

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

Back to the Questions

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 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, than 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, than 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.

Bottomline, if anyone tells 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

Current Non-deductible Real Estate Loss

If you currently have a real estate loss and you can’t deduct it, don’t add to it. Don’t take any depreciation in the current year, or if you do take it, take the minimum by allocating all depreciable basis to either 27.5 years (residential property) or 39 years (non-residential property).

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.

It was 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 don’t take it. There is no ‘use it or lose it’ rule with depreciation.

Real Estate Income

Let’s say that after the direct and indirect expenses you still have taxable income. That’s great. In that case, the next question is whether you also want to (and can) offset other income. Your goal here is to find out how much depreciation expense you can use.

Once you know that number, calculate depreciation under the most common depreciation strategy. A portion is allocated for land, which is not depreciable, and the rest is real property, depreciated over 27.5 years if it’s residential or 39 years if it’s not.

When to Use a Cost Segregation Study

If you can handle still more depreciation, it might be time to consider a cost segregation study. We’re going to cover this in more detail next month and have a sample template. The IRS has recently created an audit guide specifically on cost segregation studies. And, unfortunately, some companies are using that fear tactic to charge huge fees. You do have to follow the guidelines, but the good news is that there is no reason why you can’t do your own cost segregation study. Make sure you tune into next month’s coaching study to learn the particulars.

The Cost Segregation Study allocates the basis from longer-term property to shorter term property. It doesn’t create new depreciation; it accelerates or front-end loads the depreciation.

If you make use of accelerated depreciation, you will also need a strategy to replace the depreciation as time goes on. After about the sixth year, you will have a lot less depreciation and that means you may have taxable real estate income. To avoid that, we usually recommend that you plan to buy additional real estate every five years.

There is one more benefit with a Cost Segregation Study if you’ve had property for a while. You can catch up the depreciation.

Catch-up Depreciation

This is the strategy that Dr. Greene used. He had property that he’d owned for a number of years. Let’s just use one of those properties as an example.

Property #1: Basis $150,000

There had already been $30,000 that had been allocated to land. The $120,000 remaining basis had been allocated for 10 years. The total accumulated depreciation was $43,636. The study showed that $30,000 could be allocated as 5 year property. That meant that the $30,000 would have been already depreciated since the property had been owned for 10 years. The depreciation associated with that $30,000 had totaled $10,909 at the 27.5 year rate. But at the new 5 year rate, it would have all been depreciated. So, the difference ($30,000 - $10,909 = $19,091) of $19,091 is a one time depreciation expense.

This catch up depreciation is reported on a special form, Form 3115, and filed in the year in which you catch it up.

The strategy here is that you take advantage of this catch-up depreciation in a year when you either have a lot of real estate income you can use to offset or you qualify as a real estate professional and can use that loss to offset your other income.

If you use your catch-up depreciation too fast, like Dr. Greene did, you’ll end up creating suspended losses, which tie up potential tax savings.

Suspended Loss Strategies

What do you do if you already have suspended losses? I’ve mentioned that you have two options: offset future real estate income or take advantage of the losses when you sell. Let’s look at those plus one more strategy that might work in the right circumstances.

If you have suspended real estate losses, it’s like sitting on money that doesn’t give you any interest. If you want your money to work for you, like I do, then don’t leave it sitting idly somewhere. If you already have suspended loss, reduce or eliminate the depreciation you take so you don’t increase the problem. If you still have losses even without depreciation, you have a bad investment. That would be what I would focus my attention on. How do you turn that bad investment into a good investment?

Meanwhile, though, let’s look at suspended losses. The first strategy is to use those losses against income. Reduce or eliminate depreciation on your existing properties so that you can create an income to offset that suspended loss. You can always do catch-up depreciation later for those properties. Meanwhile, your goal is to get those suspended losses used up as soon as possible.

Eventually, you may decide to sell the properties that have created the losses. Please pay attention to this next point. It’s an important one. The loss carryforward is actually calculated by property. If you have a property with a lot of suspended losses, then that is the one you need to sell. And, second important point: If you have previously elected to aggregate the group, then any loss you may end up with can not be used to offset your other income. The loss sits there until all the properties in the group are sold.

When you sell, the suspended losses are used to increase basis. That’s really not fair, by the way. The increased basis will reduce your capital gains, which would be taxed at a maximum of 20%. However, the accumulated depreciation must be recaptured at 25%. You’ll have to pay a minimum of 5% in extra tax (25% - 20%) because you over depreciated your property. If you have an overall loss when you sell, that loss can be used to offset other income provided you hadn’t previously aggregated the property with another group.

**We discussed aggregation during the April 3rd coaching class.

Strategy Always Starts Here

Strategy always starts with two things: Where are you now? and Where do you want to be?

The strategy will take you from one point to the other. In the case of depreciation, you need to know what your real estate income, net of direct and indirect expenses, is. That’s the starting place. And then you need to know what the idea amount of depreciation to take will be. Can you make use of a real estate loss? Do you already have suspended losses to use up? Do you plan to be a real estate professional soon?

Don’t just jump into a technique like Dr. Greene did. The best idea in the wrong circumstances can be very expensive.