I just submitted my taxes and it felt good. The sense of accomplishment this year was especially gratifying because I got a lot of money back. Normally if you get money back it’s because you didn’t do a very good job of calculating your estimated withholding. But 2013 was the first year I got to file a Schedule E for my rental property. And although rental property taxes can be pretty complex, I was able to decipher most of the IRS code and be extra aggressive when it came to claiming landlord deductions.
I probably spent around 20 hours doing my taxes this year and I’d say about 19 of those hours had to do with reading up on rental property deductions(researching online, reading books and posting questions). As I’ve explained before, I don’t think taxes are that difficult but you have to have an interest and some free time available in order to do them on your own. I ended up interviewing two CPA’s this year(both around $500) but after a few minutes, it was clear that real estate was not their specialty. I know there are CPA’s out there that specialize in real estate and charge $500 but I haven’t found one(local to me) yet.
If I spent 20 hours and I could have paid someone $500, that means I was paying myself about $25 in after-tax dollars(remember AFTER-TAX is different than pre-tax). That’s about the same amount that I get paid at my day job(after-tax) so I’d say it was still a good value for me to do my taxes myself this year. I could(and I still might) write an entire series about being a landlord, but for now I’m doing most of my real estate and landlord writing on the RentPrep Blog. This topic(depreciation) was just too juicy to write about anywhere else though. This is the exact type of article that I know my readers have come to love, so enjoy.
My New Real Estate Landlord Tax Deduction Bible
My go to resource during this whole real estate tax learning process has been the NOLO Landlord’s Tax Deduction Guide. NOLO is a very cool law service that publishes all types of legal books in an easy to read format. Ever tried to read an IRS pub? It’s like deciphering ancient Egyptian Hieroglyphics. This book was only $30 and it’s tax deductible if you’re a landlord(I learned that in the book! haha). I’m actually planning on reading their Small Business Tax Deduction Guide too now that my small business(online/freelancing) income is starting to pick up.
Basics of Real Estate Taxes
The basics of real estate taxes are pretty simple. But when you start getting into more advanced topics like depreciation and expenses, that’s when you’re going to have to do a lot of research yourself or hire a CPA who specializes in real estate. I’m going to talk about converting a property from a primary home to a rental since that’s what I did last year around July.
When you own and live in your own home, there are some nice tax breaks available: mortgage interest deduction, property tax, etc. When you rent out your home, the main difference is that instead of deducting all those things, you now have to count them against your income. Here’s an example:
Let’s say I collect $1,800 a month in rent. My monthly expenses are ~$550 for interest, $300 for property tax, $400 for HOA fees and $50 a month for homeowner’s insurance. There are also normal maintenance expenses/repairs(broken appliances, plumbing problems, etc) but we’ll ignore those for now for simplicity.
So my total income from this property would be $1,800 and my total expenses would be $1,300. That leaves me with a $500 profit that I would have to pay taxes on at my marginal tax rate(close to 35%- federal & state).
When you convert a primary residence to a rental property, you no longer get a tax deduction for mortgage interest and property tax but you do get to count them as expenses to offset the income you’re now bringing in. So in a way, you really lose these valuable deductions by renting out your property. But you do get to count things like homeowner’s insurance and HOA fees as expenses once you’re renting out your property so that sort of balances things out.
So far, everything makes sense. If you spend money on your property, you can deduct it from your income. You’ll only have to pay taxes on the income you make. Seems fair enough right?
In Walks Depreciation
Depreciation is defined as the wear and tear on your property. The government lets you depreciate the value of your structure and personal property over 27.5 years. But the nice thing about this deduction is that most(if not all) properties are going to last for longer than 30 years. So depreciation is really a phantom expense since at the end of the day, the value of your property will likely go up.
So let’s say you buy a property for $280k and the value of the building(can be found on the property tax bill) is $70,000 and the value of the land is $210,000. You can’t depreciate land but you would be able to depreciate $70,000 over 27.5 years. That would equal about ~$200 worth of depreciation expenses that you could take every month. In our example above, now you would only have to pay taxes on $300. Depreciation just saved you around $70 in taxes(assuming a 35% marginal tax rate).
$70/month might not seems like a ton but over 27.5 years that will be around $23,000 in free money(sort of). That’s a decent chunk of change. The only caveat is that if you end up selling your rental property for a profit, the government will say, “Hey, we’ve been giving you a depreciation deduction for the past X years and now your property value has gone up. What gives?!” In this case, you would be forced to pay back a depreciation recapture tax at a rate of 25%. Here’s an example of how depreciation and the recapture tax works:
If you buy a property in 2009 for $280k and your building value is $70,000 you would be able to depreciate that amount over 27.5 years. Let’s say after 3 years, you decide to sell your property and it goes for $300k. Over 3 years, you took $7,200 in depreciation deductions. When you sell your property, you’ll have to pay 25% recapture tax on the $7,200 in depreciation you took and you would have to pay long term capital gains taxes(15%) on the $20,000 in profit you made.
Depreciation might not seem as appealing when you realize that you have to pay it back at 25% but if your marginal tax rate is 35%(like mine), you’re guaranteeing yourself 10 cents on the dollar plus all that time of tax deferral if you can increase your depreciation deduction. There are even ways to avoid the recapture tax completely by completing a 1031 exchange or holding onto the property until you die(the basis is reset at this point so all of the recapture taxes will go away). There are other ways too, all legal of course
One thing to keep in mind is that whether you take depreciation or not you will still have to pay back the recapture tax if/when you sell. So you might as well take it even if you don’t want to.
How to Maximize Depreciation
In my book, tax deferral is almost as good as not having to pay taxes since there will always be strategies to lower your taxes in the future. But once you pay taxes, you can never get that money back(that much I can guarantee). So in my case, it would behoove me to figure out a way to take as much depreciation as I possibly can. Even if I do end up selling the property, I’ll have made 10 cents on the dollar plus all that time of tax deferral.
When I looked at my property tax bill, I saw that my land value was $210,000 and my building value was $70,000. This would give me a nice small deduction but the valuation of the building seemed way too low. Most people use the property tax records to calculate depreciation basis but you don’t have to. The IRS is very lenient/flexible in how you calculate your basis as long as you can back it up. A lot of CPA’s use 80% of the purchase price as the building value although NOLO clearly states you should never use a flat percentage.
What I ended up doing was going to a website called Building-cost.net and entering in my property’s information into their free calculator and they came up with a building value of around $210,000 – the complete opposite of what my property tax bill showed($70,000). Their calculator uses numbers based off the National Building Cost Manual by the Craftsman Book Company which is the same exact book that NOLO recommends. Let’s update the example from before with my new depreciation value:
I’m still collecting $1,800 a month in rent and my monthly expenses are ~$550 for interest, $300 for property tax, $400 for HOA fees, $50 a month for homeowner’s insurance and ~$600 a month in depreciation($210,000/27.5 years/12 months).
Without depreciation, my monthly profit was $500 a month but with depreciation the IRS now sees that I’m losing $100 a month. I’ve also got a monthly cash on cash return of $500 plus about $300-$400 a month going towards principal.
That $100 in losses can even be used to offset your active income(from your day job for example) as long as you have a MAGI less than $150,000(phase-out begins at $100k). Obviously if you’re a landlord, you don’t want to be losing money but you do want lots of phantom expenses like depreciation since your cash flow will remain the same but to the IRS it looks like you’re losing money.
I’m not sure if my method of calculating depreciation will hold up under an IRS audit but I made sure to do a good job documenting everything and staying within their guidelines. The IRS knows that there’s a lot of gray area when it comes to calculating depreciation so I don’t see any reason why I shouldn’t be ultra-aggressive here. If the IRS questions your method, you would only be subject to a penalty if you were off by more than 200% AND the error resulted in more than $5,000 in unpaid taxes.
Readers, do you own a rental property? What value did you use for calculating your depreciation basis? Do you think it’s smart to be this aggressive if it will save me this much money or do you prefer a more conservative approach?
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-Harry @ PF Pro