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🤑 Pay less in taxes by understanding exactly how depreciation works

✋ High five for all who participated in the recent poll…see results below.

HOW TO SAVE MONEY WITH DEPRECIATION

We're going deep in the weeds in this newsletter and if you take the time to study this stuff, I guarantee you'll save some money!

Many of the wealthiest people in our country earn millions of dollars per year and pay almost nothing in taxes.

How?

They invest in real estate and utilize “depreciation” to offset their cash gains from real estate and other businesses. I personally made a good amount of money last year, and was able to offset much of those gains by utilizing depreciation. However, this is specific to certain types of assets like rental real estate and cannot be used on assets like mortgage notes.

However, you don’t have to be worth millions to utilize it.

How does it work?

Disclaimer: This isn’t tax advice and I’m not a CPA. Consult your own CPA to see if these strategies are right for you.

Bonus depreciation is the ultimate loophole and the main deduction big-time investors take to wipe away their taxable income.

Before we talk about bonus depreciation, let's talk about normal depreciation.

It is the act of slowly deducting the initial expense of an asset against your taxable income over the life of the investment.

For residential real estate, that is 27.5 years, and for commercial real estate, the time frame is 39 years. That means, every year, you get to take a "deduction" against your taxes equal to 2.53% of the value of a commercial asset and 3.63% of residential investment.

Residential:

100% (value as a whole) / 27.5 (time frame) = 3.63% (depreciation per year).

Example: Residential building worth $200,000 / 27.5 years = $7, 272 per year in a tax deduction, every year for 27.5 years.

This means, for residential real estate, each and every year, when you file your taxes, you can take a $7,272 deduction against your taxable income.

Commercial:

100% (value as a whole) / 39 (time frame) = 2.56% (depreciation per year).

Example: Commercial building worth $1MM / 39 years = $25.6k per year in a tax deduction, every year for 39 years.

This means, in commercial real estate, each and every year, when you file your taxes, you can take a $25.3k deduction against your taxable income.

This is a big deal. Here's how it works in practice.

Let's say you buy a $1MM commercial real estate asset that generates $60k of net operating income each year (6 cap). You can deduct $25,641 (2.56%, or 1/39th) from your taxable income each and every year for 39 straight years.

That shields a HUGE portion of your income each year from income taxes (around 42%).

How many W-2 employees do you know that get to keep 42% of their paycheck shielded from income tax?

Terminology - What is "basis"?

The basis is the amount, in dollars, of your capital investment in a particular asset for tax purposes. If you buy a property for $1MM, your basis is $1MM. But as you deduct things like depreciation, or any of the other tax deductions your basis drops.

If you put a new roof on a property, your basis goes up. If you buy a neighboring parcel, your basis goes up. Any capital investments you make in a property add to your basis.

Now make sure you understand that investments are different from operational expenses, and can't be entirely deducted in the year they happen. In the example directly above, each year you deduct the $25,641 as an expense against income, your basis drops down from the original purchase price of $1MM by the $25,641.

When you sell an asset later or wind down an investment, your remaining basis is what you can use to offset your capital (taxable) gains on the sale.

If you sell this $1MM asset for $1MM in year two, after you had taken the $25k in depreciation, your basis drops to $975k, so at that scale, you would have a $25k taxable gain:

$1MM (sale price) - $975k (remaining basis) = $25k (taxable gain).

NOTE: You can accelerate depreciation over quicker time frames for different parts of the property.

Different parts of the asset can be depreciated on different schedules based on their "useful life". Some schedules are faster than the 27.5 or 39-year time frame, so you can depreciate them faster.

For example, a sidewalk has a "useful life" as determined by the IRS of 15 years. So you can assign a value to the sidewalk and depreciate it faster, over a 15-year time span.

Land, or the dirt the building sits on, can't be depreciated because it has an "unlimited useful life" in the eyes of the IRS. In the original $1MM example, the land value is subtracted from the full purchase price and then you do the math on the depreciation. So if the land was worth $200,000 then you would subtract $200k from 1 MM and get $800k for your depreciation calculations.

Each asset has a depreciation "schedule" provided by the IRS. This is also called a "useful life". Some parts of the asset are 5 years, some 7, 10, 15, etc. Many things like the roof, fencing, windows, flooring, air conditioners, and more can be depreciated much faster than 39 years because the tax code has different lifespans for those items.

The goal is to get as big of a tax deduction as possible early on because a dollar saved now is a lot more valuable than a dollar saved 39 years from now.

What is bonus depreciation?  

It allows you to deduct a certain percentage of cost in the first year an asset is put into service. At the time of this writing, you can write off 80% of the value of anything that has a useful life of 15 years or less. A certain percentage, as laid out in the tax code, is depreciable all in year 1. That percentage changes depending on the administration and the tax code.

For years 2015 through 2017 first-year depreciation for all the items on a 15-year schedule or less was set to 50%. It was scheduled to go down to 40% in 2018 and 30% in 2019 and then 0% in 2020.

But then Trump got elected, and he enacted the Tax Cuts and Jobs act. This moved the percentage to 100% from 2017 to 2022. 80% in 2023. 60% in 2024. 40% in 2025.

And the real estate folks had a party. Real estate investors would pay for an outside consultant to come in and set values to all of the assets on a depreciation schedule. This is called a cost segregation study.

How much does it cost? For a residential rental property up to $500k in value, it can be as cheap as $1,000 to get this study done. For commercial properties, it depends on the size and scope but the costs are substantially more (never had a commercial one done).

Back to how it works:

It is not uncommon to allocate 15-30% of the overall purchase price on a 15-year or faster timeline. This means you can deduct up to 30% of the overall price of the asset in the first year. This is very powerful. I am an LP (limited partner) in many syndications which do this and I get a portion of the depreciation to offset my taxes as a LP.

For example, lets say I invested in a $3MM apartment and the sponsors got a cost segregation company to look at the property and they determined that there were $700,000 in items on the property that fell into the 15-year or less useful life period. The bonus depreciation would allowed the sponsors to write off 80% of this expense in the FIRST YEAR. That is a $560,000 deduction year one and I get a piece of it depending on how much invested. Just remember those amounts will change (80% in 2023, 60% in 2024, 40% in 2025). Unless the law changes, the bonus percentage will decrease by 20 points each year over the next several years until it phases out completely for property placed in service after Dec. 31, 2026. So bonus depreciation will be 0% for property placed in service Jan. 1, 2027 and later.

These deductions from bonus depreciation can also offset income from other previously purchased properties in the same "income type".

So if you have a portfolio of $10MM worth of commercial real estate and it's producing $750,000 a year in NOI, all you have to do is buy a few properties each year to make virtually all of that income tax-deferred. And remember, even after the first year, you still get to deduct more depreciation on that other 70% of the asset over 39.5 years.

I did not want to get in too deep but wanted to mention that The Cares Act (passed during COVID) made it so you can carry the passive losses from depreciation back five years to income made in 2015 onward. That means if you had a lot of real estate gains in 2017, bought a property this year, and took a big loss through bonus depreciation, you can go back and amend your 2015 returns and get a tax refund for the taxes you paid back then.

Also, in The Cares Act, you can use the new depreciation guidelines to catch up on assets purchased in the last three years. Meaning if you purchased a property back in 2017 and didn’t do a cost seg study and accelerate depreciation, you can go back and do that and amend your returns. And you can carry these losses forward into eternity to offset future earnings if losses are remaining after you've wiped out all of your income.

This is a beautiful thing for real estate owners.

Accountants don't always like doing this stuff for their clients for one simple reason:

The more deductions you take, the more work they have to do to file your returns. If you ask your accountant about bonus depreciation and they respond: "I don't recommend that, you'll have recapture later and you'll end up paying these taxes at some point." I disagree. Yes you have to recapture but a dollar saved now is worth a lot more than a dollar saved later. Get aggressive with your tax planning and find an accountant who wants to work for you and not for the IRS. There are a lot of terrible accountants out there. I've fired crappy ones, and I've paid good money for good ones. I recommend the latter.

A few very important notes:

Losses from depreciation can't offset active W2 or business income unless you are a "real estate professional". I'm a real estate professional because I mainly focus on my real estate company, so I can deduct these losses against my passive business income from other investments / ventures.

Recapture is the tax you pay on the difference between your new (lower) basis after the deductions and your original basis. So if you deduct a $1 million building with $300k of depreciation and then sell it for $1 million, you have $300k that will be taxed at the recapture tax rate.

Cost segregation studies don't always make sense. You aren't really "saving" on taxes, you are deferring taxes into the future. If you don't plan to hold a building for more than a few years, there is little reason to spend money on a study. If you can't use the losses because you're in a really low tax bracket then studies don't make sense either.

Make sure to consult your CPA on these issues. This is not tax advice.

POLL RESULTS

The poll below was done a few weeks back and the results are in. The poll was asking which topics where of interest. This is how it broke down:

• 40% - Interested in learning more about mortgage notes

• 30% - Interested in learning more about syndication investing

• 20% - Interested in learning more about creative real estate 

• 10% - Interested in learning more about self directed IRA and 401K

• 0% - Interested in learning more about private lending

So based on the results, the next few newsletters will be focused on mortgage notes and syndication investing. There will be future newsletters discussing creative real estate topics and self directed IRA investing but to a lesser extent.

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