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Have you heard this before? “We’ve owned the property for years. We can’t sell our rental property because the depreciation recapture will kill us”. I’ve had a couple of property owners call me this past week to tell me that. If depreciation recapture is new to you, check out IRS publication 544.
Basically if you have had a rental property, you weren’t able to write off the purchase price the first year you owned it. Instead you have had to spread out the purchase price and improvement costs over the expected life of the property. Unfortunately, you didn’t get the full tax deduction that year, but had to spread your deduction out. In accounting speak, you have to capitalize the purchase. Ouch. When Uncle Sam said “I want you”, he should have said, “I want your money”,
But it also has two much bigger implication that get overlooked. First, the time value of money reduces the value of the deduction. Second is the recapturing of the depreciation you claimed when you finally sell the property. Let’s address these items in order.
Time Value of Money
We all understand that milk and eggs cost less today than they will in the future. But that’s not because they are any more inexpensive to produce. It’s because your dollar will not be able to buy the same amount in ten years that it can today. Because of this, the value of being able to either deduct costs or reinvest money has much more value today, than it will in the future. That’s what we call the Time Value of Money.
What does this really mean practically speaking? Let’s suppose you replace a roof on your rental property and that it costs you $10,000 to replace the roof. You will have to spread out your costs for replacing the roof. For every year that you spread out the costs, your deduction has less impact on your taxes. Twenty years from now when you replace the roof again, will it cost you the same amount it did twenty years ago or will it cost you more? It will cost you more, because your dollar will buy less. All this means that you should try to avoid depreciation and instead aim to for immediate deductions. We’ll look at some strategies to doing this in a minute.
Taxes on my tax deductions?
Yes. You should know that Uncle Sam doesn’t give you anything for free. When you sell an asset such as a rental property, Uncle Sam wants you to pay him taxes on the amount you depreciated. This is called depreciation recapture. The IRS assumes that when you sell your rental, that you are recouping the costs on all of your improvement expenditures and they want their deductions back.
Example: Sue buys a rental property as an investment for $100,000. Sue is forced by IRS rules to depreciate the purchase costs over time. Now Sue wants to sell the property that is fully depreciated. However Sue’s CPA tells her that Uncle Sam wants to tax Sue on the depreciation deductions she has taken. To add insult to injury, it’s not all based on Sue’s tax bracket, but for some of it Uncle Sam wants to tax at 25%.
Normally, residential property is depreciated over 27.5 years. If you haven’t owned the property a long time, then you shouldn’t have a lot of depreciation to recapture. In Sue’s case, she owned it more than 27.5 years which is why she owed depreciation on the entire purchase price. Not only did she have to depreciate the purchase price, but any improvements she added to the property. New roofs, new kitchens, remodeled bathrooms or replacing windows, would typically all be classified as improvements that needed to be depreciated.
(Note: The tax calculations are very complex and have multiple sub characterizations. The examples given here are given only for the purpose of a simple example and not for tax calculations. Please consult with your CPA.)
So, what are we to do?
How to get more tax deductions instead of depreciating items now
Unfortunately the IRS says you must depreciate any items that you can. But there’s some wiggle room here when it comes to things that happen after you purchase the property. Having said that, remember we don’t want to cheat on our taxes, but let’s take advantage of every allowed break they give us. The key according to Sandy Botkin a CPA and former IRS agent, “with rental and commercial properties, you always prefer to have fix-ups classified as repairs and not improvements” Lower Your Taxes Big Time.
He suggests 8 strategies in his book to do this.
8 Strategies to get more deductions from your rental repairs
- Segregate repairs from improvements. – In referring to the IRS tax manual, “fix-ups that would be a repair when made separately would be an improvement when made as part of a general overhaul of the building”. Mr. Botkin suggests that you separate out the scope of work of repairs from improvements. If you just bought a rental and are remodeling and considering a new roof, wait. Consider leaving the roof separate and instead of replacing it (an improvement) repair it with similar materials (a repair).
- Fix a minor portion. – Similar to the roof above, rather than replacing an entire kitchen, can you simply make repairs fixing water damage, painting the cabinets, etc.
- Use similar, comparable, or less expensive materials.
- Fix damaged areas only.
- Repair after an event. – Improvements happen in advance, repairs happen when your tenant calls you about a clogged toilet. Hey, there might be a bright spot to clogged toilets after all.
- Repair during occupancy or between tenants. – The IRS knows that a lot of investors try to buy a property, renovate it and then rent it out. Then they try to expense the new kitchen, new bathrooms as repairs rather than depreciating them as improvements. Accordingly, you should wait until you have owned the property for some time and have tenants in place before making the repairs.
- Make sure that the fix-up costs are classified properly on your books.
- Try to replace less than half of any repair – If a single room needs carpet, don’t carpet the whole house.
BONUS: There’s one more technique pointed out by Lorraine Evans, a Sacramento CPA to real estate owners.
9. Keep your repairs to under $2,500.
Per new IRS guidelines issued for 2016:
Effective for taxable years beginning on or after January 1, 2016, the Internal Revenue Service in Notice 2015-82 increased the de minimis safe harbor threshold from $500 to $2500 per invoice or item for taxpayers without applicable financial statements. In addition, the IRS will provide audit protection to eligible businesses by not challenging the use of the $2,500 threshold for tax years ending before January 1, 2016 if the taxpayer otherwise satisfies the requirements of Treasury Regulation § 1.263(a)-1(f)(1)(ii). – IRS increases de minimus deduction
Depreciation isn’t Always a Bad Thing
Well, the recapture part is. But, might there be time when our tax bracket is more than 25%? High income earners in in the 40% tax bracket would gladly accept the 25% tax bracket. In addition, even if you can’t expense an item completely, might you be able to shorten the depreciable life time and therefore increase your deduction now rather than spread it out over 27 years? The answer is yes.
Asset classes have a depreciable life span. Even though rental property has a depreciation life of 27.5 years, carpet and appliances only have a life of 5 years. Put another way, you don’t have to spread the purchase of your appliances over 27.5 years, you can spread them out over just 5 years.
Example: Sue purchases new carpet for her rental for $3,000. By entering the the carpet depreciation in her books as having a 5 year life span, she is able to deduct $600 for each year of the 5 years. If she were to use the 27.5 years, she would be deducting only $101 each year. Furthermore, if Sue were to use MACRS rather than straight line depreciation, and take 50% bonus depreciation, she could speed up some of her depreciation deductions even sooner and deduct $1,800 the first year!
Here’s a chart with the standard class lives. However, to use these shorter class lives, the assets must be classified properly the first year they are placed into service in your accounting system. You cannot go back afterwards and change your class life after the filing of your taxes.
|Property Description||Class Life|
|Most personal property used in rentals||5 years|
|Residential Rental Properties||27.5 years|
|Non Residential Properties||39 years|
|Furniture and Fixtures||7 years|
How to completely defer depreciation recapture
Most rental property owners are familiar with 1031 exchanges. In a 1031 exchange, they sell one property and using the proceeds buy another property and deferring the taxes. The problem often is the timing.
There are complex timing issues with exchanges that require you have a property to purchase and move the sale proceeds into within a limited number of days. The problem is, you are having to time the sale of one property with finding, acquiring and purchasing of a second property that you really want to have. It’s not uncommon to find a property seller who is in escrow or who has sold an investment property and now they are desperate to find their second property before the time limit expires. They have a property in mind to buy, but then that deal falls apart. When that happens, they often are forced to buy less desirable properties at the last minute. Now they are under a time crunch and in a rush to buy something.
A better solution than a simple 1031 Exchange
A better solution to this is to find another investor who desires to purchase their initial property. An investor probably doesn’t have any intention of moving into the property. Consequently, they are probably much more open to closing at a time that is more convenient to your finding a new property. When an end user wants to buy their rental, they will not want to wait several months before moving in.
Example: Upon learning of the tax consequences of the sale of her rental, Sue decides she would like to do an exchange. She finds an investor who is willing to give her a 180 day escrow . This allows Sue plenty of time so that she can find a replacement property. After Sue’s due diligence is complete on your new property, she and the investor buyer to proceed with closing both escrows and doing the 1031 Exchange. This methodology lets Sue avoid all of the time pressures of selling her property that she would encounter with an end user.
Take it to your grave
Everyone wants to leave an inheritance to their children right? Okay, maybe you’d prefer your grandchildren. This is probably the simplest way to avoid depreciation recapture, but who knows what your kids will do with it. I’ve seen some owners keep properties for years saying they were going to give it to their kids. Then, after they pass their kids are not able to take care of the property and then sell it. I’ve been been involved in two different probates sales where the children or grandchildren received a lump sump of money from an inheritance only to spend it on fast cars and fast women. After years of work and savings to maintain a rental property, that’s pretty discouraging. The only good news is you won’t be around to watch them waste it.
To avoid this, make sure you have a trust or a will set up as probate fees for handling properties in the Sacramento area are specified by state statute and are equal to real estate commissions. A will can also dictate how and when the proceeds will be distributed.
With some good legal help you could set up a strategy for the sale of your rental property and have the funds go into a trust fund that dribbles money out to your grandchildren for college instead of fast cars.
How to spread out depreciation recapture when you’re ready to sell
There’s another option if you want to sell your rental property without using any of the above strategies (dying really isn’t a strategy is it?). According to IRS publication 537 you can spread the sale of your rental property out over a period of several years. This is similar to selling while carrying a promissory note except that it spreads out both your depreciation recapture and capital gains.
This has many of the benefits of a 1031 exchange except that you aren’t trying to find another property to move your money into. This is an excellent technique for liquidating the final property in a series of 1031 exchanges.
Example: Sue has a property that she originally paid $100,000 for and is now worth $200,000. The property has been fully depreciated and is subject to $25,000 in depreciation recapture. In addition Sue also owes taxes on her capital gains. Sue is in high tax bracket this year and would like to reduce her taxes. She wants to defer the income from the sale of her rental property to years where she’s likely to be in a lower tax bracket.
The Installment Sale Solution
Sue enters into an installment sale that spreads the purchase over 5 years. Sue has a promissory note and Deed of Trust that protects her in case of default of the buyer. By spreading her payments out over 5 years, Sue defers some of her capital gains to later years when she will be in a lower tax bracket. She also spreads the depreciation recapture out over 5 years, so that each year she only has to pay $5,000.
(Note: The tax calculations are very complex and have multiple sub characterizations and tax consequences. The examples given here are given only for the purpose of a simple example. Please consult with your CPA.)
Note, this does not reduce the amount one needs pay in recapture. It simply is a form of a payment plan with the IRS that allows you to spread the taxes out.
Talk to your CPA
As always, you should consult with your CPA and tax planner before proceeding down this path.
A special thanks to Lorraine Evans, CPA for reviewing the tax components of this article. You can contact her via her website Evans CPA or via email at Lorraine Evans.