Free Educational Video
Should I Depreciate My Rental Property?
Total Watch Time: 10 Minutes and 38 Seconds
Should I Depreciate My Rental Property? – Video
Bob Weaver, CPA: What is depreciation? The depreciation is the write off of an asset over time as it ages. You buy a home– This is absolutely the coolest in my pretty little accountant’s head. This is the coolest thing I know of that you get, especially here in the Bay Area. You have an opportunity to have an asset that has been appreciating, going up in value for quite some time here. In the past couple years there’s been some serious appreciation in this neighborhood. The neat thing is that the IRS rules think that the value of your property is actually going down and that you need a tax write-off to reflect that the value of your property is actually going down.
That’s true of an automobile. Automobiles don’t appreciate. They depreciate. What happens to your car over time is basically what they’re saying happens to a house over time. If you keep it in good repair, are you going to have more repairs on a hundred year old house than you do on a five-year-old house? Of course, you are. We’re writing off the cost of repairing it. We’re recovering those costs anyway to keep the house up but we get this thing called depreciation. We get to write off this piece of property over time.
My rule of thumb is that you start with your land. The value of the land is never going to go down. It doesn’t depreciate. Other than a hillside in a 200 inch a year rainfall, where the whole place is literally eroding away. Here in the Bay Area, the land never goes down in price. It doesn’t depreciate. You can always knock down what’s on it and put up something new.
There you don’t get any depreciation on your land but as a rule of thumb, we accountants tend to use the 80/20 rule. Meaning that the structure itself is probably worth 80%. It’s a little lower than that in the Bay Area, maybe 70/75% of it is structure and 30% of it is land.
As a rule of thumb, accountants like to push it a little bit, at least I do. Use the 80/20 rule; about 80% of your property, your new rental property is depreciable. We have to figure out how long is that write-off going to take.
Somewhere along the line I guess we had people in Congress fighting over whether it was going to be 25 years or 30 years. I think that’s how they came up with the 27 and a half years because they just compromised — they couldn’t agree so they split it down the middle. You’ll find that most of the residential structural islands are going to get depreciated at this rate but we always like to see if we can figure out a method for busting out what isn’t.
27 and a half years I found that on the 80/20 rule, if you do the math, if you take 80% of your purchase cost and divide it by 27 and a half years, you get about a 3% depreciation rate. That’s a nice rule of thumb. How much depreciation am I going to get on this property that I just bought? Well, let’s see, I bought a $100,000 rental. You can do in other markets. I’ve got a couple that are under a hundred thousand. You can buy those for a hundred thousand and you’ll get a three thousand dollar a year depreciation write-off.
Just do the math a little bit. You by a $500,000 rental property which is much more likely here in the Bay Area and you’re going to get $15,000 write-off every year just based on the structure alone. Let’s say you have more than $15,000 of net positive income other than depreciation. You’re going to be paying tax on the net because you’ve only got $15,000 in depreciation on this half million dollar rental. Well, what we try to do here, in that case, is to find what items in your property that we can justify, we can identify land improvements.
Land improvements can be anything from the bushes in front of the house to the trees in the yard, to the fence and to the driveway. What we find in the uniform appraisals that are done for Freddy and Fanny is that information is right in the cost section of the appraisal report. Virtually any real estate, any residential real estate that’s subject to a Freddy and Fanny appraisal. I’m going to have at least this information as far as to what to write off-for 15 years.
A lot of residential appraisers depends upon the appraisers go into more detail. We often find appliances with no air conditioners and whatnot separately listed in itemizing the appraisal report and we try to pull those out of the appraisal. The second thing we’re allowed to do, and this is fairly recent and I’ve just started to do is I’ve been asking realtors to appraise, if you will. The new rules says by any reasonable means. I figure anything reasonable is somebody with more experience than the IRS auditor. That includes me, but don’t ever accept me as the estimator.
If we’re really trying to boost your depreciation because you’re paying taxes on your rental income, we really do want to boost your depreciation. We’ll ask your agent to write a letter saying that, “I think the appliances are about $2000.” We’ll pump up your depreciation because we get to write these off, actually off over faster over 15 years because all these depreciation items get front loaded and we can get the write-offs earlier.
Who wants to pay taxes later versus now? We’re always trying to bump up the depreciation in the early years to try to get the best tax benefit. What’s really neat about this is that between the two of us, we get to figure it out. Nobody can tell us we can go for these or not go for these as we see fit.
Everybody’s situations different. You might not need the letter from the realtor. You might want the realtor to be as aggressive as possible, but we have that option. That’s a discussion that we get to have. The one thing you need to know about depreciation is when you take it, we have what’s called recapture. Which means once you take this depreciation on your real estate, we have what’s called your basis. My basis is what I bought this rental for. That’s what it starts for. How much did that rental costs? That’s where we start. Every year you take depreciation, it drops the basis of your property.
Let’s say you bought a five hundred thousand dollar rental in San Mateo, and you’ve owned it for a few years. Over the years, you’ve taken a hundred thousand dollars worth of depreciation. Your basis in that property has gone from 500 to 400. When you sell this property, you’re going to have what we call recapture. You’re going to have to bring that depreciation you took back and the income when you’re computing your game or, God forbid, you have a loss, you’re going to be reducing your loss for the amount of the depreciation you took, because your property’s basis is now only worth $400,000, but again, when did you get this depreciation? You got this depreciation early. When are you paying the taxes under the depreciation you took? Later.
That’s the game of depreciation. If you do a 1031 exchange which we’re going to have some folks talk to about later, that recapture never happens. As long as you basically exchange till you die, that’s a very popular planning term. Exchange till you die. Don’t ever bother selling it. Just keep exchanging it. Defer the taxes forever.
This is more for folks that are into apartment buildings or that sort of stuff. If any of you are doing, I’ll just quickly go through this. We actually have a cost segregation report that we do where we actually go in, we get an engineer and they break down the cost. They actually do a full detailed study when you’re really trying to– First of all, you have to have a lot of money involved.
It takes at least a half million dollars of project cost to make this even think about working, because you pay an engineer to move as much of the property that you can get into those shorter lifespans to boost up your depreciation. You’re even getting even more aggressive. To do this, you have to have an engineer. Like I said, most properties don’t warrant this, but I did want to– You break it out to the structural components, land components, appliances, but like I said, I do this, what I call a many cost segregation where I find these on the appraisal report. I’m basically doing a far less formal with– It’s quite a bit less aggressive, but I know I can justify it. I can’t go as far as a real engineer could.