I’m always shocked when I’m chatting with an established real estate investor and the conversation takes an unexpected turn.
Social interactions aren’t my strong suit, no new information there.
What’s supposed to be surprising is the number of real estate investors who don’t understand depreciation. Their approach is: buy property, make money, dump receipts on accountant’s desk and receive tax return.
I recognize that while I don’t have a degree in accounting or finance, my current and former careers forced me to learn about those subjects. Not everyone has that luxury.
So, I thought I’d take a crack at explaining the basics of depreciation…with comics.
Everything Becomes Worthless
The IRS has a very gloomy outlook. They think that everything you build or buy (except land) will become worthless one day.
I like to image the moment I buy something an IRS agent with a pocket protector and a bad attitude starts staring at a clock; biding his time until my asset is worthless.
That angry IRS agent even has a coworker (equally angry of course) who calculates his wait.
Why do they care?
Spreading Out the Cost
In short, the IRS cares because they’re greedy.
Before we get explain that, let’s throw in a definition:
Deduction. The glorious act of adding a cost to your expenses, thus lowering your taxable income for the year.
If you buy a $5 pen for your business, you can deduct the cost ($5). At the end of the year that’s $5 less taxable income.
We should be able to apply the same approach to a $100,000 house, right?
A $90,000 loss in the first year? Sweet. In fact it would take 10 years before this house has any income. There’s one rub, the IRS only gets paid if you make money…and they are not known for their patience.
How do they get their money sooner? They make you depreciate the cost, ie spread out the deductions over the lifetime of the asset. That’s why IRS agent number 2 has to calculate how long until everything becomes worthless. In the case of our house its lifetime is 27.5 years (IRS agent 1 and 2 couldn’t agree on 27 or 28 years). So, we can deduct 1/27.5 of the cost every year.
Now, the clever IRS gets paid right away.
Bringing Down the House
Let’s take our example further. What happens if after 11 years you get real tired of that house giving you lip, so you tear it down.
The logical thing to do is deduct the unclaimed depreciation right away.
Aren’t you the optimist?
Did I mention the IRS was greedy? Kiss that $60,000 good bye because you don’t get to use it.
Well, technically that’s not true. You add the remaining depreciation to your land cost (which isn’t depreciated) and it comes into play when you sell. It just doesn’t lower your taxable income when you destroy the home.
Selling the House
Remember when you tore down that house? That was a dream sequence.
You wake up and the house is untouched and it’s four years after you bought it. It also, happens to be the day you sell it.
When you sell your home, the taxes get ugly. Well…uglier.
Let’s define a term that accountants LOVE to throw around:
Cost Basis. Your assets current value, according to the IRS. For our purposes, it’s the cost of the house minus deducted depreciation.
Let’s look at some potential sales prices and how cost basis comes into play.
$100,00 Sales Price
Say you sell the home for $100,000 after 4 years (assume we’re in an enchanted land with no closing fees). Those angry and cunning IRS agents are quick to realize that their “everything becomes worthless” theory wasn’t correct.
The IRS wants to recover as much of the deducted depreciation as possible. They do this by adding the depreciation deductions back onto your taxable income. Lucky for us, they can’t reclaim more than your profit. In this case, the numbers are easy (imagine that).
Our IRS agents aren’t well suited for coming up with clever names, this process of recovering the depreciation deductions you claimed is called…depreciation recapture. Accountants looking for job security often confuse people by referring to it by the tax code section: 1250.
$90,000 Sales Price
If we sell for less than or initial cost, then the IRS can’t recapture the full deducted depreciation.
$120,000 Sales Price
Were you hoping we were finished defining terms? You would be wrong.
Capital Gains. Profit derived from buying and selling. According to current tax law, capital gains from something owned less than a year are “short term” and taxed at the regular income rate. More than a year, it’s called “long term” and taxed at the lower rate of 15%.
Say you buy a baseball card for $100 and sell if for $200, your $100 profit is called capital gains. If you owned it for more than a year, you’d pay $15 in Long Term Capital Gains (15% x $100).
Why do we care? Any sales proceeds above our depreciation recapture amount is a capital gain.
There’s a way you can avoid paying taxes on the sales proceeds. Score!
Well, at least you won’t pay them right away.
When you sell a home, you can purchase another home with the proceeds. The IRS allows you set the cost basis for your new house equal to the cost basis of your old house and not pay taxes on the sales proceeds!
When you sell the second home, that’s when you pay the piper.
Let’s say we took the proceeds from the above example, bought another house, held it for three years, and sold it for $140,000.
The math looks complicated, but just remember:
- No taxes due when you sell property 1.
- Taxable income (depreciation recapture) is always initial house cost minus current basis.
- Capital gains are always final sales proceeds minus initial house cost.
This is called a “Like-Kind Exchange.” Or a “1031” if you are a fan of speaking in numbers.
You can do multiple Like-Kind Exchanges in a row. It’s a good way to build your real estate empire without paying Uncle Sam every step along the way. Just remember, nothing is certain but death and taxes. When you sell the final property, the taxes are due.
Shorter Lifetime Property
Our examples so far used a house which depreciates over 27.5 years. There are other types of property which depreciate faster: stoves for example depreciate over 5 years. That’s going to be treated the same as 27.5 year property, right? Just divide by 5 instead of 27.5
Have you even been reading this post? It’s never that easy.
Here’s a chart:
If you’re one of the latter group, don’t both looking it up. Use TurboTax or an accountant to crunch the actual numbers.
What’s important is the allowed depreciation deductions for 5, 7, 10, and 15 year property decrease by year. You deduct the most in the first year, less in the second, even less in the third, and so on.
Outside of that, how you handle calculating cost basis, recapturing depreciation, and throwing property away (removing from service) are similar.
Really want to know the details? Check out this link.
**Bonus** In 2013 you can deduct 50% of shorter lifetime property costs! Thank you Obama!
Wrap It Up – The Good and Bad of Depreciation
Congratulations, you know everything about depreciation!
No you don’t. This article skims over a lot of detail, but it gives you a decent enough understanding to realize depreciation is a double edged sword.
- It’s labor intensive to track. Your time could be better spent making money.
- You’re not allowed to deduct asset purchases right away.
- When you sell a property, you must repay the deducted depreciation.
- Claiming depreciation deductions without paying more money out of pocket helps your cash flow.
- 5, 7, and 15 year property do tend to lose value over time. You shouldn’t need to recapture the full depreciated amount.
- Depreciation is essentially the IRS giving you a loan without interest. You get to claim a loss every year and pay them back when you sell the property. It would be better if they just let you deduct the full cost up front, but you can’t win them all.
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