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Financial Alchemy: Depreciation, Passive Losses, Real Estate Professionals, And Uncle Sam (Part 4 — The Introduction Continues)

This is part four of a three four five-part series on depreciating real estate investments and how it affects your tax bill.

Part 1 talked about the basics of depreciating real estate investments.  In a nutshell, you can depreciate the non-land value of your real estate investments (but not the home you live in) over a 27.5 year period and use this depreciation as a “passive loss” write-off against your regular income.

Part 2 discussed the IRS limitations on the same.  For folks earning $100K per year or less, you can only write off up to $25K of passive losses in a year.  For every dollar you earn above $100K, you lose 50 cents of maximum allowable depreciation write-offs; at or above $150K per year in income, you can no longer deduct passive losses.

Part 3 discussed a Hummer-sized loophole in the IRS limitations having to do with real estate professionals who invest in real estate.  If you qualify as a “real estate professional” in the eyes of the IRS, then you no longer have the $25K limit or the $100K threshold.  You can write off pretty much all your depreciation against your income.

My standard caveat on such matters:  I am neither an accountant nor a tax attorney.  More importantly, I am not your accountant or tax attorney.  What follows is simply my layman’s understanding of a particularly obscure part of the tax code.  Before you try any of the below, be sure to consult with the appropriate professional.  ‘Nuff said.

Cost segregation, or component-ized depreciation takes the tax benefits of real estate investment depreciation to the next level.   Instead of depreciating the non-land portion of your real estate investment over the 27.5 years the IRS mandates for real property, you segregate or component-ize the investment into smaller chunks of personal property, each of which has a much more aggressive depreciation schedule.

Take our imaginary $500K property from part 1 of this series.  You’ll recall that $225K of that was the land value, leaving $275K to be depreciated over 27.5 years.  What if that $275K could be depreciated much more quickly?  Clearly, you’d end up with more depreciation that you could write off against your income.

Here’s how you accomplish this particular piece of tax alchemy.  You break down your $275K depreciable real asset into numerous smaller depreciable personal assets.  Your $275K property is actually the sum of:

• 14 windows at $500 each = $7000.  The IRS allows you to depreciate windows over, I believe, 7 years.  Instead of depreciating $7000 over 27.5 years (a paltry $250 per year),  you depreciate $7000 over 7 years, giving you $1000 per year in depreciation.  Voila!  Out of thin air, you’ve created an additional $750 in depreciation, which at a 30% tax rate, saves you $225 per year.
• 1 stove = $300.  You can depreciate appliances over 5 years.
• Blinds and drapes = $5000.  5 year depreciation schedule.
• Fence = $10,000.  15 year depreciation schedule.
   
• etc. etc. until you component-ize the whole property.

Your $10,000 per year depreciation now suddenly – magically — goes up several times, with your tax savings doing a similar bit of alchemy.

(For more information on cost segregation, you simply have to read what Jeff Brown has to say about it.)

Tags: Industry, Investing

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