Report on presentation made by Michael Plaks on April 27, 2004
Written by Bob Bartel of UPOA. Reprinted with permission.
Depreciation is the incremental tax write-off of business or rental property over a period of years. It can significantly reduce the owner’s tax debt, but the savings must be repaid at the time that the property is sold. Normally, rental property is depreciated over a period of 27 1/2 years. This depreciation is taken on the improvements to the property only, not the land itself. Let’s call this information “Tax Planning 101.” It’s what most of us learn about tax preparation when we file our Federal Income Taxes. It’s also probably all we will ever learn about depreciation unless we have a real estate savvy CPA, or attended UPOA’s April presentation.
Our first speaker of the night, Michael Plaks, is a federally licensed Tax Advisor who specializes in tax strategies for Real Estate, tax return preparation, and IRS problems. Michael began his presentation by explaining some basic terms, including the difference between a “repair” (a deductible expense in the year in which it occurred) and an “improvement” (an asset which is depreciated over a period of time). If you’re not sure which one is which, ask yourself these three questions:
- Does it restore the property to its operational condition?
- Does it increase the value of the property?
- Does it extend the useful life of the property?
If your answer is “yes” to the first question, it is probably a repair expense. Common examples are repainting, fixing leaks, plastering, fixing broken windows, replacing door locks, and patching damaged floor covering. A “yes” answer to the second or third question though indicates that an improvement has been made, and the cost of the improvement should be deducted over a prescribed number of years. The length of depreciation is determined by the nature of the improvement. You have now completed “Tax Planning 201”, congratulations!
Improvements don’t have to be in the form of construction done on the property, like roofing or putting in new carpet. They can also be existing objects, like a refrigerator or an air conditioner, lighting, even trees and driveways. All these things can be depreciated at different rates, depending on their average “useful life expectancy.” This is the basis for asset segregation.
When using asset segregation to lower your taxes, you utilize the principle that money in your pocket now is better than money in your pocket 10 or 20 years from now. Accordingly, you look at that rental property as a collection of assets of various types and differing periods of depreciation. The land still can’t be depreciated at all, but the improvements to the land, things like roads, fences, drainage, and landscaping are now separated from the value of the land and depreciated over 15 years.
Inside the house, appliances, furniture, carpets, lighting, and shelving are now recognized as having only a 5 year life. If you separate their value from that of the house, you can depreciate them five times quicker, substantially increasing your early depreciation.
“But wait, there’s more,” we hear Michael say. Personal property and land improvements can also qualify for accelerated depreciation under current tax laws which are trying to stimulate investment. He goes through an example that shows how a $100,000 rental property which only used the 27.5 year “straight” depreciation method might only produce a deduction of $5,212 after two years. Utilizing asset segregation, acceleration, and special allowance could increase that deduction to as much as $13,208 in his example. For a person in a 30% tax bracket, that would put almost $2400 more money in the investor’s pocket! This is not too good to be true… it’s the law!
But there is a catch. While you always want to declare depreciation, because the government will assume you did, and charge you recapture fees when you sell the property anyway, you may not want to use these special techniques if you already have sufficient deductions to bring your tax to zero. For those whose real estate income is considered passive income, they must also be careful that they don’t lower their income sufficiently to trigger paying the alternative minimum tax.
Okay, now get ready for graduation. Here’s the test. Your have held the property long enough so that it is fully depreciated, and now want to sell. Do you owe “recapture taxes” on the full amount that you have depreciated, and what is that tax rate? The answer may surprise you. Yes, you do owe recapture tax, but it is not at the 15% long term capital gains rate now in effect. The land and any appreciation of the property would be taxed at 15% since it was not depreciated at all, but the recapture tax on the rest is a stiffer 25%!
Even here though, there are tax shades of gray. What if all the appreciation is in the land, and the value of the house did not appreciate, and maybe even went down? Then the recapture tax (25%) may be replaced by the capital gains tax rate (15%) to the extent that the sales price reflects appreciation of the land and lower building value. If you want an “A” in class, you use a 1031 exchange when you sell, and defer your tax completely.
What happens if you have been filing your taxes using only the straight line depreciation method all these years? No problem. You can still go back and file an amended return. Not just for the last three years, as is usually the case for amending returns. Asset segregation can go back to the year of purchase, and the savings can then be declared on your current return if desired!