Free Educational Video
How To Maximize Rental Property Depreciation?
Total Watch Time: 22 Minutes and 13 Seconds
How To Maximize Rental Property Depreciation? – Video
John Hyre: We’re doing it. Maximizing Depreciation. This is a big one for you guys, this is a very big one for you. Some tips.
Land improvements. If it’s outdoors and God did not put it there, it’s probably depreciable, and most of you aren’t depreciating it. Sidewalks, fences, patios, money python fence. What do we call landscaping?
RWN Member: Shrubberies.
John: Thank you. This is the bay area at its finest.
Shrubberies. Anything outdoors that God didn’t put there, probably depreciates on a 15 years schedule, which is probably about 7% per year. Just for perspective, when my youngest daughter was six, she ran around the house going, “Ni”, so, we catch them young.
Let’s say you have a property. Let’s say you buy for 100 grand, 20 grand as land. Well, of that 20 grand on land, I’ll bet you, really, 10 grand is land improvement and it’s depreciable. If you’ve now got the ability to depreciate 10 grand that was not previously depreciable, how much did you crank up your depreciation on average? About 700 bucks a year. It’ll add up. There’s one answer in part. I don’t know if you’re doing that on your properties.
RWN Member: No, I’m just depreciating the land.
John: That’s common. Not breaking things out to the nth degree. I’m going to get into more detail, because there are several categories in depreciation that I want you to know.
Personal property. My rough definition of personal property, it’s indoors, if a tenant can steal it without using power tools, it’s probably personal property. Appliances, furniture, carpeting if what? It’s been tacked down, if it’s been tacked down. Now, if it’s been glued down, what happens when you try and rip it up? You destroy it, it’s been functionally made part of the property, that’s actually been litigated.
If it’s tacked down, which is usually the case on residences, the carpet is a separate five year asset, because what’s the benefit of these personal property assets? They depreciate faster. You don’t get more depreciation, you just get it faster. Instead of 3.6% a year, you converted the rental property, 27 year schedule, you converted it to personal property. You get roughly 20% a year, so it’s a net present value game. I get more deductions sooner by doing that.
What else would apply besides floor coverings, cabinets? Now, it depends on how the cabinet’s done. My wife is an artist, she does sculpture, she’s brilliant, she is utterly brilliant in this category. How does that impact her in real estate? She over-rehabs properties, especially low income. I remember– and she has a twin sister, they’re both very attractive and are both very Latin. Latin women have a different view, typically, always generalizations, always exceptions, yes, I know, because someone will come up and say, “Not all of them are like that,” no, I didn’t say that. But they do have a different approach to using their feminine side to get what they want, as a generalization. My wife went into a Lowes where they have the kids that teaches you how to do like tile, and she wanted to learn how to tile, so she goes in with her twin sister.
Both of them are looking very nice, and the poor 20-year-old didn’t know what hit him. They got way more lesson than anybody else would have gotten because they’re just like, “Wait, can you show me-look, see this-can you show me this thing again, please, I did not see that.” We bought, during the crash, this property. It’s a duplex. We bought it for $42,000 and needed about 200 bucks to get it in shape. It was ready to go, it was a short sale. It rents for $1,300 total per month, we don’t have any trouble filling it up, it’s low-income, non-war zone. She and her sister tiled, I swear, every square inch of that place. They went nuts.
I’ll bet it’s like a Cask of Amontillado something where there’s a guy tiled in behind the wall. How is this relevant? Cabinets. Can a tenant remove a cabinet? Here are two differences. You’ve got a cabinet that’s tiled into the wall, you need a Jackhammer to rip that thing out the way she’s got that thing in there, or, what if it’s a cabinet– Let’s use our tenant as Schwarzenegger. You’ve got the cabinet, it’s hung, can he remove it without power tools? “I have taken the cabinet and I give it to the people of the state of California,” that’s personal property. He was able to remove it, it wasn’t made part of the property functionally.
You look around, what’s not part of the property functionally? Ceiling fans, window treatments, guys, let me give you a trick on vacation properties. Do you guys do any vacation properties?
RWN Member: No. Not really.
John: Not really? Okay. Well, a hypothetical trick then. What’s nice about vacation properties is the furnishing of them. How do you get tax-deductible property in your house? Because normally, it’s got to be in a business. You can’t use it personally and write it off. What do you do? You have this property in an LLC, not in a corporation, not in S, not in a C. It’s one of the reasons we like rentals and an LLC. You’ve got these vacation properties, you furnish them beautifully, you depreciate the furniture to zero. Usually, that takes five years.
You depreciate it to zero. You then distribute the property like a dividend. You deed the property functionally. It’s called a bill of sale, to yourself. It is now your property. It’s already been paid for before tax and you put it in your house. I do this with the furniture in my law office. We buy nice furniture in the law office. We make sure to buy it in a separate LLC, not through the escort the law practices run through. We depreciate it over five years. Once we’ve gotten our write off, that’s how long it took to get the whole write off, five years. We distribute the property, and it goes home. Oh, daddy like. Right?
Loan assets. All the costs of getting a loan; appraisal fees, points, commissions, inspections blah blah blah blah, you add all that up, that’s a loan asset. Now, there are two reasons to do this, to break it out this way. The first is, you depreciate over the term of the loan. Here’s you want some gray? We’ve got some gray for you, babe. The gray is this, we’re supposed to depreciate the loan over its term. Let’s say it’s a 30-year loan amortizing but with a five-year balloon, what’s the term of the loan? The law doesn’t say. What are we going to say?
RWN Member: Five years.
John: Five years. It can be 20% a year. Five years. Let me give you another reason to segregate assets, not directly depreciation related, but will create savings. Let me make three examples. I’m going to make an example of stove, carpet, and loan. I have a stove. It costs me 500 bucks. I depreciate it by 200, so my balance is 300. Everybody got that? I throw it out. Or I show up to the rental, the tenants are gone and so is my stove. Or it’s broken, we throw it out.
Remember to write off the assets that you get rid off. The rule is if you completely dispose off, that’s important, you completely dispose off the asset, you can write it off. But this applies in some subtle contexts people don’t always think about. With a stove, it’s a no-brainer.
Now let’s switch it to the carpet. How you define things matters. Well, the definition of is is. Right? Definitions matter. If I say the carpet is the whole house, the whole house, and I rip out the living room carpet because the dog piddled all over it, and so we have to get rid of it and replace living room carpet.
Did I dispose off the entire asset? No. I was supposed to only have a part of the asset. Why? Because I had to find the asset as the carpet throughout the house. Now let’s say I take the time, and on my books, and on my tax return, I say the carpet for the living room, the carpet for bedroom number 1, the carpet for bedroom number 2 et cetera. I have redefined what is an asset. I get rid of the carpet in the living room. Now have I disposed off the entire asset? Yes. Now I can write off the balance. Can we get a mic over here?
RWN Member: I don’t need a mic, I’m fine.
RWN Member: On the loan, I’d say if you have a loan that’s $100,000, would you say that you’re depreciating the sum of the loan payment like the commercial loan?
John: I’m not talking about amortization of the loan, I’m talking about depreciation of a loan asset. For example, you paid $2,000 commission, $500 in points, so that’s 2,500 bucks, and let’s say $400 and other miscellaneous loan costs, so $2,900. That $2,900 is the loan asset that you’re depreciating. The technical term is amortized, but depreciating works fine.
In fact, let’s come to my final example. I showed you what to do when you throw out a stove. I showed you what to do when you throw out a carpet and better to define the carpet in a certain way. When you throw out a loan, write off the loan cost. When do you throw out a loan? It’s called a reify. As long as it’s with a different bank.
I had one client. She wasn’t a client at the time, we just happened to look at our returns. She had 30 Section 8 properties. She had about $3,000 average per property loan cost, and she reified. The key is you have to reify with a different bank. If you reify with the same bank, the IRS considers it as a continuation of the old loan. If you reify with a different bank, you threw out the old loans. Write off the loan costs, pretend you sold them for zero. In her case, $3,000 per property with about 30 properties, that was around 90 grand, with the losses that we created. She became a client very quickly.
RWN Member: Properties I bought, I don’t know what the carpet was– How do you value that?
John: How do you value it? That’s a great question. Again, good, these are good questions, it means you’re listening and you’re thinking, good. Couple of thoughts, Hey, what if you haven’t done this before, can you go back? Yes, you can go back in time unlimited. You can amend, and that’s usually painful. There’s a form called a 3115. Don’t try that at home, that is a god awful form. Form 3115.
Let’s say you’ve owned 10 properties for 20 years, you never depreciated the land improvements at all. You can tell the IRS we made a mistake, that’s what the 3115 is, “We didn’t do something right, we wanted to change our method of accounting. We did an accounting move wrong, we treated land improvements as land, we’d like to fix that. It’s 20 years, we didn’t depreciate for 15 years,” so the whole cost of the land improvements, you’ll get it all at once. In other words, you file a 3115 and you say, let’s make up a number. “I have 10 properties at 100,000 each 10,000 worth of land improvements,” I’m just making the number up. 10,000 times 10, it’s $100,000 of land improvements I never depreciated.
I can file a 3115 saying, “Give me $100,000 write-off, I messed up,” and you can go back unlimited. Unlike the amending period, you can only amend three years back. With a 3115 to change depreciation, you can go back unlimited. Now, that’s not an easy form, it’s complex. You have a cost-benefit decision, you talk to your accountant and say, “Here’ is how much money I would get back,” and by the way, if it’s a large number like 100,000, they’ll usually make you take it over four years, 25 grand a year for the next four years, and extra write-offs. Now, does this help you if you cannot take passive losses? No, because it’s still a passive loss.
You’ve got to be able to use the passive losses. If you can’t use passive losses, why would you go through all this work to increase your depreciation? Makes no sense. It’s only if you can use the losses or if you’re showing gains that you want to drop, but if you have gains and you would actually get some sort of refund or you can use the losses, you go back and say, “I didn’t depreciate land improvements, I didn’t depreciate personal property, I didn’t depreciate loan assets and I didn’t write them off when I was depreciating them, when I got rid of them.” You can go back and correct those things.
We’ve seen some cases where there’s real money involved, you’re showing a gain and you want to reduce the gain, or you can actually use a loss if it results in a net loss or drives the income on the property below zero. That’s when this makes sense to do.
RWN Member: Sir, I’m sorry. I just wanted to clarify something. These are relatively new acquisition. I haven’t done any accounting for them yet – it’s going to be next year.
John: These are new acquisitions and you haven’t accounted for them. You’ve just got to make sure whoever does your tax return knows what they’re doing. This is what you want them to do. Now, it’s a lot easier if the bookkeeping is done in such a way that they know how to do this. In other words, if you give the accountant a good set of QuickBooks that breaks out the properties this way, you’re going to get a much higher likelihood that they correctly do the return. That first return, in particular, is key because you’re setting a pattern with them, you’re setting a pattern.
RWN Member: Sir, it’s just in my specific case, this was bought from a rehab, so I don’t know quite exactly-
John: Okay, how do you value? Going back to the original question, how do you value? You guess, you don’t want to be 100% wrong. What do I mean by that? He bought a property and he just puts on the books. Puts on the QuickBooks, “I think the sidewalk is worth 500 bucks. What’s 100% wrong? Well, if the IRS comes back and says the sidewalks worth [00:14:00] $300, and that’s assuming they win because they can’t just assert, they’ve got to prove it as well, they’ve got some burden to bear. They say the sidewalks worth $300. Is $500 100% off of %300? No.
Now, if they come back and say it’s worth $250, $250 is exactly 100% off of 500. Now you pay a 20% penalty called. It’s called a gross valuation misstatement. Anytime, for income tax purposes, that you’re valuing something, here we’re valuing, relative to the cost of the property, what portion was the sidewalk. If you’re 100% wrong, you pay a 20% penalty. If you’re 200% wrong, you pay a 40% penalty. What’s the goal? Guess high, but not too high. You don’t have to have an appraisal. You can. There are companies that do cost segregation studies, and if the property is large enough, let’s say, 400 grand or more, it’s probably worth getting a cost segregation study done because it’s more sustainable on audit.
Let me give you one last piece on the depreciation.
Think about breaking things apart. For example, I break out the furnace in a rental. Why would I do that? It doesn’t change my depreciation. If I list the furnace separately on my tax return or on my books, it does not change the depreciation, it’s still 27 and half years. Why would I do that?
RWN Member: Because it’s likely to break down.
John: If it breaks down, I can write it off the balance. What do I look in my properties? I break them down. I start thinking, I might break out the roof. If I have to reroof it, I want to write my roof off. Things like that, you want to break out. By the way, there’s a detailed way to learn this. That bookkeeping course, look in the rental section, it goes in the great detail on what I have put here on a summary format. Great detail. Typically in Quick Books, when you make this kind of entry, you’re breaking up the property in the carpet by room, sidewalk front yard, sidewalk backyard, patios, et cetera. When you’re breaking it down, you’re typically going to have 50 to 100 items on a good-sized rental.
Size does matter. Like on a small rental. I buy low income stuff in Columbus, Ohio for 20 to 30 grand all day long. Low-income, non war zone. I can still get those deals. Now, they’re management intensive. If you don’t know how to manage low-income people, they will rob you blind. It’s like human locusts that’s strip all organic material down to the barrack shiny metal. I used to be a nice guy. Dealing with those people has made me not so charitable. I get really good deals on those properties, but on a $30,000 property, am I going to break it in the 50 line items? No, because the number on each one is so small, the savings aren’t that large. I’ll probably break it into about 7 to 10 lines, maybe 15 if I’m feeling crazy one day.
Size matters, the larger the property, the greater the detail you break it down into. We have included super detailed instructions in that course, on how to do this. Here’s what I would do, because a lot of you have time that’s valuable, learn how to do the books enough that you know how to them and you can spot BS. You’ve got to do it for maybe two or three months. View it as an investment.
Now, I’ll come to your question. View it as an investment, hand that course to a bookkeeper. Hand the course to a bookkeeper because your time is worth way more than what a bookkeeper will charge. What do we pay for a bookkeeper? I would say low-end, college student accounting majors, sophomores preferably. You got them for three years, they want experience. You can get those guys for 10 to 15 bucks an hour, all day long. 15 out here, anywhere else in the country, probably 10 bucks an hour. Out here, at 15 an hour, you’ll still starve and die.
That’s how we hire, by the way. When we hire bookkeepers, I usually hand them the course and just give them something and say, “Run with it.” On the high-end, I’ve seen people up to 75 bucks an hour. I’ve never seen a bookkeeper actually worth that much, but I’ve seen them charge that much. I would say the high-end is 40 to 50 bucks an hour. My wife does some bookkeeping work on the side because she’s managed our rentals for all these years and done the bookkeeping. She usually charge around 45 to 50 an hour. She knows her stuff inside now, and it’s fast. Plus, she can do really complex situations. Just to give you a feel for that, take a look in there.
I go in immense detail on how to break a property you like to sell. If you’ve got multiple properties that are in the six figures, this is real serious money. Sir.
RWN Member: If the assets have been sold, can you go back and amend?
John: If the assets have been sold, can you go back and amend? I wouldn’t. You could, theoretically. I wouldn’t. Plus, there’s recapture. There’s a net present value on bracket arbitrage consideration, when increasing depreciation. Some people say, “If I depreciate, my gain goes up when I sell. I have the recapture bracket at 25%, versus capital gains of 15%. In other words, I have a property, I buy it for a hundred, I depreciate it by 30, I sell it for 120. I got 50 in gain.” The 30 in gain, that’s attributable to depreciation, gets taxed at 25%. The 20 attributable to actual capital increase, gets taxed at 15% to 20%, depending on your bracket.
It’s a little bit higher, but here’s the thing, what if I’m getting the depreciation deduction on a 40% bracket? That’s arbitrage. I pay it back at 25%, if I ever pay it back. Here’s some great tax planning, don’t sell. 10/31, and then die. That’s awesome tax planning, because you never pay the depreciation back. Plus, the kids get a whole step up and basis on the property. Now, I don’t say we have to accelerate the depth, it’s great tax planning, but your fees to me stops, so we’ve got to balance things out.
RWN Member: Basically, we’re talking at cost segregations daily, and the value of that.
RWN Member: If you have multiple properties, and once you have it segued out, so then, as things wear out, break, whatever, you can fully depreciate that item down to zero and then replace it with a new one. Is that how they work?
John: It’s the functional equivalent. When a unit breaks and still has a balance, an undepreciated balance, it’s like you sold it for zero. Bottom line is you take a loss on the remaining balance.
RWN Member: You can replace your whole growth or whatever if it’s segued out half this year half that year, you can do it all-
John: There was a recent change in the regulations where even if you don’t break it out as a separate asset, if you made a special election to be able to write off partial assets, there’s a special election now that you can have to write off partial assets, but most people don’t have it in place. It’s only prospective. You can’t elect retro. So, what I’m telling you is, even if you don’t have things segued out if you make the election to write off partial disposition of assets, you should be able to write some of these things off even if they’re not separately on your books. I’ve got a question over here.
RWN Member: If you have land improvements, do you set the value at the replacement value?
John: If you have land improvements, do you set the value at the replacement value? Not necessarily. It has to be proportional to its value on the property. I’ll give you an example. I buy a rental for $15,000 in Columbus. I’ve done it. Let’s say replacing the driveway would cost, let’s just say 5 grand. I can’t say that the driveway is a value 1/3 of the house, which if I took straight replacement value, that’s what would happen. Really, if it’s going to be replacement value as your methodology, there has to be a large ‘depreciation deduction’ to show it relative to the house.
Maybe it’s 5 grand to replace it, but given the total value of the house, 4,500 is the age wear and tear deduction. Therefore it’s a net value truly under cost of 500 based on its present condition. It’s a fancy way of saying you’ve got to scale it down to the size of the property.
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