EP 002 - How Depreciation Creates Millions in Tax Savings and Freed Capital for Real Estate Investors

I will discuss and some techniques to maximize the tax benefits of depreciation and answer common questions about the expense. Some of the topics we will discuss are:

- Basics of depreciation
- Calculating depreciation for real estate investments
- Cost segregation 
- Missed depreciation opportunities

Transcript

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All right, welcome everybody. This is uh it's a beautiful Wednesday night here, and we are going to talk about depreciation, aka the Phantom Expense, and how to use depreciation to save millions in taxes and in capital. So, depreciation is probably one of the greatest topics when we talk about the tax advantages of investing in real estate. So, when we talk about investing in real estate, um, it's one of the first things you want to understand when we're thinking about the tax advantages is depreciation. So, what we are going to talk about in this webinar is first we're gonna identify what is depreciation. I'm gonna give you a good definition. Uh, this is gonna be great for you guys. First, being introduced to the topic, and I'm gonna show you how I calculate depreciation, how it should be calculated. And then we're gonna dive a little deeper into the implementation of recognizing depreciation, and this is gonna give you an understanding of what it looks like on your income statements and the effects of this depreciation write-off, and how that's gonna allow you to reduce your taxes and free up additional capital. To start off, what is depreciation? Depreciation is defined as a reduction in the value of an asset with the passage of time due to, in particular, to the wear and tear. So here's a great example. We have this brand new shiny Dodge RAM. When you purchase it, it is shiny new, it is a business asset, it is not yet an expense, it is capitalized over time. Through the wear and tear, it will resemble more of what you see on the picture on the right, and it will lose value. And the loss, the uh the calculated loss of value of your assets is what we call depreciation. Uh now, depreciation is a deductible expense that you write off against your taxes, and it is also a non-cash expense expense, and that's why they call it the phantom expense. Now, the and now we're gonna see because no cash is leaving your pocket and you're still getting this write-off. Now we're gonna be able to see some opportunity here to make our taxable income much lower than the the revenue minus expenses that we are pulling in from our real estate investing portfolios. Another thing I want to clarify that a lot of people may confuse is that real uh depreciation is not devaluation. I think a lot of people get that confused. Depreciation will continue and it is independent of the market value of your real estate. So here's an example of a Brooklyn brownstone. If you own that brownstone for 30 years and is a residential property, it would be fully depreciated on your books. But if it is in a trendy neighborhood of Brooklyn, it may have tripled or quadrupled in market value over that time. Another thing I want to clarify is that land does not depreciate. Land does not depreciate. So you want when you calculate depreciation, you want to calculate the value of the items that do depreciate the buildings and the structures and the man-made items that will diminish in value over time because land and the soil in the ground is not considered to be something that will lose value over time and wear and tear, we will not depreciate the purchase price that we will allocate to that land value. Next, I'm gonna talk to you about how do we calculate depreciation. First step that we want to do is we want to determine the basis in the asset. When we consider the basis of the asset, that is how much we are gonna put on our balance sheet uh as this real estate purchase that is that we're investing in. So to calculate this, we have the purchase price and then included in this uh the basis of this property, we have the closing cost and any capital improvements. A capital improvement would, for instance, be adding a uh a deck to the house or adding a new roof. Let's say if you're a bird investor, a lot of those repairs, uh the significant repairs or adding a new stove and a kitchen, those would all be capital improvements that would be capitalized into the value of your purchase and depreciate it over time. So once we have our basis in the asset, we need our depreciable basis. So we have the basis of the asset as a whole, and now what we have to do is we have to take out that land value because as you recall, land does not depreciate. So, in this instance, let's say we do some analysis, we look at some comps and tax assessments and appraisals, and we find that basically we have a ratio of 80% to the building and 20% to the land in this example. We purchase it for $500,000. That would mean $400,000 would be attributable to the building and depreciate over time, and then $100,000 would be attributable to the land and would not depreciate. So now that we have this depreciable basis of the $400,000 in that example, if it is a residential property, we will depreciate it over 27.5 years or 3.6% per year that we will recognize in depreciation. So in this example, we would get roughly $14,500 per year in depreciation as a write-off. Now that sounds pretty good, but we also got to figure that we're paying off our mortgages, and when we pay off our mortgages, we're paying down equity, which we can't write off, so that's just paying off an account receivable. But here's where it gets good, and where you can really see the benefit of your depreciation. And what we want to look at is cost segregation. Cost segregation are studies used by the taxpayers to identify portions of this real property that are separate tangible personal properties and have shorter depreciable recovery periods. So within this house or apartment complex that is depreciating over 27.5 years, we do a study and identify different pieces and elements attached to this real estate that is going to depreciate faster. When we do this, we break out values of these different components. We depreciate the components individually at faster rates, and that will allow us to recognize more depreciation of this purchase in the earlier years and get more of those write-offs faster. So we can get those write-offs faster, free up more capital in the form of reduced taxes. Here are some components that are going to depreciate faster than 27.5 years and give you those greater write-offs. We have perhaps fence, 15-year property would be the fences, the curbs, driveways, sidewalks, shrubbery, plumbing, electrical, sprinkler, five-year property, dishwasher, stove, laundry machine, countertops, toilets, heaters, furniture. These are all things that are going to depreciate over shorter periods of time than 27.5 years. So we write these off faster. When we have greater write-offs, we're likely to be operating at a loss when we report our tax on our real estate income on our taxes, and that loss may be able to create refunds to that for capital that can get reinvested into your real estate. But I'm getting ahead of myself. We'll talk about this in greater depth a little bit down the webinar in a few more slides. Bonus depreciation. This is where the cost segregation study gets really powerful, but you need a knowledgeable CPA who can really who really know to take care of this before you miss the opportunity. Bonus depreciation will allow the taxpayers to deduct a specific percentage, 100% as of right now, of depreciation of these components that are going to depreciate in 20 years or less. So once we run this cost segregation study and we identify a portion of this of this building is depreciating faster than 27.5 years, for instance, the carpet and the refrigerators and the cabinets and the electrical, all these components, we can depreciate 100% of those components in year one. But it's important that you do it in year one because if you do not do your cost segregation study in year one, you cannot recognize bonus depreciation in that year, and you will have to depreciate it over the course of its life is its expected life based on what type of components it is: the five, the ten, the fifteen year life. Catch up depreciation. This is what you can do if you may have missed out on that bonus depreciation in year one. Catch up depreciation. Let's say it's year three and we run the cost segregation study. Any depreciation that we missed out on from these other components. So let's say we have a five-year component piece of property we didn't get to depreciate faster in those earlier years. We can recognize catch-up depreciation and write off all that depreciation we could have written off in the prior years in the year that you actually do the cost segregation study and recognize that write-off at the faster rate. So not all is lost. There still is hope and value in doing cost segregation in later years. Now we are going to combine the power of depreciation with other investment and tax strategies. And I hope some of you guys get this pop culture cultural reference, but it's totally fine if you don't. Captain Planet is still the man. Okay, he's not he's kind of cheesy, but hey, trying to keep things lively here. It's a tax webinar. Um, so first example, let's combine the concept of a cost segregation plus bonus depreciation and the real estate professional tax status. Real estate professional tax status, we can go deeper into this topic, but if you work full-time in a real estate trader business and you are not an employee, so that is I'm talking to you, if you are a real estate agent, full-time investor, full-time property manager, uh, you can get this real estate professional tax status, which allows you to deduct your write-offs against other sources of active income, even your husband's income, even if your husband is a teacher or does nothing related to real estate. So here's an example when we take advantage of all these different concepts. So in this example, let's say that you have a down payment on a property for $140,000, the basis is $700. We determine the depreciable basis is $600,000, and we do a cost segregation study, and that could allow us to get $150,000 first year bonus depreciation. And that we still get the straight line depreciation of the other of the non-components, the building that is going to depreciate over 27.5 years. Our first year depreciation is going to be $154,000. This is a simplified example. Let's say that we buy this towards the end of the year and there's not a whole lot of activity. We have some repairs and maintenance, and it's break-even before we consider the depreciation. This may wind up allowing us to get that full $154,000 deduction in year one because we have so many write-offs from depreciation based on an effective tax rate of 35%. Uh, that write-off could reduce our overall taxable income by $53,000. Not $53,900. Next example is if we were to combine cost segregation and bonus depreciation with the Burr method, popular with our bigger pockets fans. Now I took these numbers and rounded them out from a case study I found in the bigger pockets forums to give a realistic example. So I saw a bigger pockets case study where someone did a purchase of $350,000, another $150 to renovate, all in around $500,000. In this instance, he put down roughly $260,000 and it was appraised at $1.1 million. For this person then had a cash out refi of $270,000. So he gets all his down payment back and an extra $10,000 for increasing the value of the property in the cash out refi. Now let's just say that the income before considering depreciation is $40,000, right? And we do the cost segregation study, and these are some estimates I made on guessing what the bonus depreciation is because I've looked at many cost segregation studies to do uh so I got a good feel for what it's gonna look like. So in this instance, let's say that we can create uh bonus depreciation of roughly $85,000 in this in this example. We are and let's say we also get another uh $13,000 with straight line depreciation. In this instance, we will be able to offset all the income, all of the revenue minus expenses that is generated from this rental property, meaning this rental property is going to be cash flow positive. But because we have this bonus depreciation, we are going to be able to offset any tax liabilities from this property. Now, if you look here, I say modified adjusted income is less than $100,000. The reason why I say this is because you normally cannot deduct passive income against other sources of active income. However, if you're a modified AGI, and most of you, that's just gonna be your salary, how much you pull in. If it's below $100,000, you can deduct $25,000 of your passive losses from real estate against other sources of active income. Then that could be your income as either being self-employed or being an employee. Now that $25,000 is phased out 50 cents per dollar between $100,000 and $150,000. So in this instance, this particular person would get, in addition to his income not being taxed from his real estate investments, we are also gonna get a $25,000 write-off because we have this additional write-offs. Because the right here we have $85,000, we have we have a total of roughly $98,000 in write-offs, and our income before depreciation is $40,000, right? So we have over $50,000 in write-offs, and we can deduct $25,000 of it against the other sources of your income. So in this instance, at an effective tax rate of $30,000, we are estimating savings of roughly $7,000, meaning that you're gonna have a cash flow positive asset and you're gonna get a tax refund of $7,000. Here's another example, another popular uh real estate strategy is the house hack, right? You live in one unit or room and you rented all out all the other units or rooms. So in this instance, let's say we bought a fourplex for $400,000, finance with FHA a 3.5% down, $14,000 down. Our income before depreciation is $18,000, and our depreciable basis is $260,000. This was an estimate made based on considering the fact that we have a four-unit property in this picture, right? So you live in one of the units right here, you rent out the other three units. So roughly three-fourths of the building we are gonna be allowed to depreciate. And remember, we can't depreciate the land. In this instance, I would estimate that our straight line depreciation would be roughly $9,454, resulting in taxable income of $85.45. And this is before considering some other tax strategies that may be able to reduce your taxable income even greater. Some strategies when you're starting off could be, for instance, um combining your vacation with business purposes, so finding business purposes while traveling to the places you like, maybe hiring a family member. Maybe you can find uh do conduct more business meetings on real estate-related topics with some of the people that you enjoy talking with and meeting with already, so you don't feel like you're always on the clock, but you're still getting these wonderful write-offs. So many other strategies that can be another just discussion, but this is just an example of how you're still gonna get to see the value depreciation even when you live in the property. Here's an example that is actually a real life example of one of my clients. Simplified and rounded out the numbers just so I can present it to you. But I did have an actual client who had $316,000 in wage income of him and his spouse. They purchased roughly seven $370,000 in real estate. We ran some cost segregation studies on two new properties, we which resulted in a bonus depreciation of $122,000. We were able to deduct all of that against his rental income for the year, and he had a successful rental portfolio. His revenues were far greater than his expenses. It was a successful year for him. But because of this bonus depreciation and some other tax strategies, we were able to implement. We were able to reduce his overall adjusted gross income by $155,000. At the end of the year, this person usually owes money on taxes, but because we implemented this strategy, we were able to create a tax refund of $32,000. Now that $32,000 is wonderful because we can take that money and reinvest it into another deal. So here's where we can use these tax benefits to free up the capital, reduce our taxes, and leverage that into more and more real estate. And when we buy more real estate, we repeat the repo the process and run more cost segregation studies and recognize the bonus depreciation. Now I'm going to just do a closing statement before I answer all your questions. So just to sum it up, the depreciation, I hope this gives you a good idea, a good overall understanding of how powerful it is to understand what depreciation is and how it can save you a ton of money on your taxes, which results in freeing up capital to reinvest into more deals. Some upcoming topics we're going to be discussing is loss planning tax strategies, and that's pretty much how we can either take advantage of this of losses. Maybe you incur business losses because of COVID-19 and the quarantine, or how we can create losses through things like cost segregation and we can use those losses to proactively reduce your overall taxes and create all sorts of vehicles to free up additional capital and invest in a way that is very beneficial from a tax perspective. We're going to talk about structuring foreign investments into the United States. This is a very challenging topic, and I can't wait to talk about it because not a lot of people know about it. But you, if you have anyone in other countries interested in investing in the US and taking advantage of the US dollar and our blossoming real estate market, we're going to talk about how you can structure that and present it to investors in other countries and tax considerations. We're going to talk about turning hobbies into legitimate write-offs and revenues so you can get tax write-offs doing the things that you enjoy doing. And also we're going to talk about quitting your job with real estate investing. So, how can you make that transition from working whatever job, day job you have, into becoming a full-time real estate investor and all sorts of tax planning and financial considerations? And I'll tell you right now, the real estate professional tax status plays a huge role in that, especially if you are married. If you want to contact me, you can reach me at MarketmarkPurlbergCPA.com. And now I'm going to scroll through and look at some of the questions. So, what happens in year two and year three if we make depreciation, if we take depreciation year in uh in year one? That's a good question. So let's say we take this bonus. I think what you mean is if we take this bonus depreciation in year one, right? We're gonna depreciate a giant chunk of this real estate up front. That's gonna mean we have less depreciation moving forwards, right? And as the asset, as a real estate investment, becomes more profitable, as we We have as rents increase and values increase, there's a possibility that you may wind up having some tax liabilities from having a successful rental portfolio. So, what you want to do with this capital that you free up from running the cost segregation studies and getting these refunds, you want to use that capital and reinvest it into more real estate so you can continue getting this depreciation write-offs and recognizing recognizing bonus depreciation on additional properties. Also, if we get to the point where you can't use all of your write-offs from your depreciation against revenues, and let's say you can't use you don't have the real estate professional tax status and your income is above a certain amount, those losses will be disallowed, meaning they'll just be carried forward into later years, and though they will reduce future real estate investable investment income. And as of March of this year, we can actually carry our losses back against prior years where we get taxable income. So if we have an aggressive strategy where you run a cost segregation study, we can now, if we can operate at a loss and we use up all our write-offs against other sources of income, we may be able to actually carry it back and get back some of that tax, so those taxes we paid in prior years going back five years. So to address that, this depreciation that occurs over time, right? You write off the value of the property over time, and what's gonna happen is when we sell this property, we are gonna have to recognize if we don't have a tax plan in place, we will have to recognize depreciation or capture on all the depreciation that we recognize in the prior years. So an example of that would say, let's say our depreciable basis is $100,000. After 30 years, we fully depreciated this property, and then we sell this property for $500,000. Well, the first hundred thousand dollars is going to be subject to depreciation recapture tax, and that could be pretty expensive. It's gonna be 25% of the of the cash of the of that $100,000 that was depreciated, right? So we have if we have to recapture our $100,000 of depreciation that we've written off over the 30 years, that's gonna result in a $25,000 tax liability if we don't plan proper properly. So what can we do to mitigate that? Well, the most effective way I've seen and that most people will do is they will do a 1031 exchange where we will defer that depreciation for capture in the capital gains tax, which is usually 15 to 20 percent. Any tax liabilities at all on that sale of a property will be deferred when you run roll it into a 1031 exchange, which is pretty much where you sell that property and purchase another property within 180 days of equal or greater value. So then we don't have to be taxed on capital gains or the depreciation recapture, and we now we have an asset of equal or greater value that we can continue to depreciate and even possibly run another cost segregation study on. Yeah, uh Hannah writes, I'm all in for additional write-offs. So let's talk. There are so many ways and opportunities to create write-offs. One of the things I'm just gonna riff a little bit on write-offs that I really want to start doing with my clients is a lot of them have children and they're interested in how we can create tax write-offs for their children. Well, here's an idea: a lot of people like the idea of hiring their children because first $12,000 that your child makes is not going to be taxed because of the standard deduction. I think it's $12,400 in 2020. Anyways, we got that standard deduction, and then after that, it's taxed at 10%, still very low. But a lot of these people are using their children to clean the carpets and vacuum and and do all this menial work. And I'm saying, listen, you don't want your kid to be a you're not training your kid to be a janitor, are you? Let's actually use this opportunity to develop their greatest skills, right? So if they're an artist, if they're a photographer, if they're into math, how can we use those skills into your real estate business and give them that confidence and proficiency in something and really develop their greatest skills? And also, if they have those skills, um, this might be an opportunity to have a really wonderful letter uh to show their professional interests and experiences that they've developed when they're applying to their colleges and might be able to increase the likelihood of them getting college scholarships and having that edge on their career before they even get into college. Another question. Um, what situation would cause us to have to pay back depreciation with depreciation recapture? Would selling a house before 27.5 years cause this to happen? Yes, so anytime you're selling an asset that has any depreciation at all, you are gonna wind up in having that depreciation recapture tax liability. So let's say you you have you own this house for um 13, roughly 13 years, right? If you owned it for 13 uh 13 years and you depreciated roughly half of the property, you would have to recognize depreciation recapture based on half of that depreciable basis, uh, which would be the amount of depreciation you recognize over time, you recapture that, and the tax liability would be 25%. However, if you like I said earlier, we have all sorts of strategies, and in addition to the 1031, I don't have enough time to go into all the things that I can do for my clients, but we can do some proactive tax planning, we can mitigate or eliminate any tax liabilities through a variety of other things. For instance, let's say you don't do 1031, but you buy other property, you can recognize cost segregation on that to offset your depreciation for capture tax. We have qualified opportunity zones, and you can look on my site. I have a whole webinar, it's about 25 minutes long, introducing you guys to qualified opportunity zones where we can defer and eliminate a good chunk of that uh capital gains and depreciation for capture tax, or enough write-offs could put us in a very low tax bracket, eliminating all of that all of that capital gains tax as well. I think I went a little bit too deep into that topic there, but I hope that gave you an idea of what the effects are and that there are opportunities to with the right proactive tax strategy to mitigate the tax liabilities associated with it. Another topic with depreciation recapture taxes, if we ran a cost segregation study, the depreciation recapture on the depreciation that we recognized for those components, the five and the 10-year components. So if we if we had those different components that we recognize outside of the real estate, the real property, and recognize that bonus depreciation or just depreciate it over five, ten, or fifteen years, we would still recapture depreciation on that amount, but that would be taxed at your ordinary income rate. Some tax planning ideas would be to take advantage of a bunch of other write-offs so that we can bring you in a lower low-enough tax bracket so your ordinary income rate is as low as possible. So it looks like we have um all the questions answered. Feel free to reach out. Um, if you have any other questions or any questions arise, you can you know where to reach me. I'd love to hear from you. Uh, for any of you watching the recorded version of this, I really hope this provided a lot of value to you and gave you a greater understanding of how powerful depreciation is, and how this can help you as when you plan for it properly and understand it and look at the whole financial picture of your investments and personal finances. You can really use this as a vehicle to save a lot of money and build wealth and really be successful in this game of real estate. So I'm about to sign off. Hope you guys all enjoyed your time and we will all stay in touch, stay in tune for my next webinars. The next one will be on next Monday on the tax losses. Hope to see you there and have a wonderful night.