Monthly Archives: August 2015

Property Depreciation: Why the Tax Benefits Could Come Back to Bite You

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When you purchase a new rental or commercial property with investment intent, you must allocate a portion of the purchase price to improvements and the remaining amount to land. The reason for this practice is that you cannot depreciate land, only improvements. This makes sense because dirt lasts forever.

Depreciation is the reduction in value of a property over time due to the particular wear and tear on the asset. Residential properties (1-4 units) are depreciated over 27.5 years, while commercial properties (5+ units and commercial buildings) are depreciated over 39 years.

This reduction in value is a current expense, yet no money comes out of your pocket. Sounds like a pretty awesome deal, right? You get to reduce your reported income by your annual depreciation expense without actually paying for anything!

But what is depreciation really? Do you think the IRS, our favorite government agency, would let you have it that easy? I’ll give you a hint: the answer starts with the letter “N” and ends with “O.”

In actuality, depreciation is similar to an interest free deferred loan with no time restrictions. You see, when you sell a property that you have been depreciating, you have to pay a thing called “depreciation recapture taxes” at a 25% rate. This 25% rate is multiplied by the total value of depreciation you have taken over the property’s hold period. So the income you are “sheltering” each month really isn’t being sheltered like you think it is, as you will eventually have to pay a portion of it back. Without prior knowledge (or having a good accountant), you could be in for quite the surprise!

I’m going to walk you through three scenarios of taxpayers in different marginal tax brackets: the 15% bracket, the 25% bracket, and the 28% bracket. I’ll then provide you with three ways to avoid depreciation recapture taxes.

The Taxpayer in the 15% Bracket

Dave buys a single family rental for $100,000 and determines that his improvement ratio is 90%. Therefore, his improvements are valued at $90,000 (0.90 x $100,000) and will be his cost basis for depreciation. Dave’s annual depreciation will be $3,723 ($90,000/27.5).

Assuming that his annual depreciation brings his Net Operating Income (NOI) to $0.00 each year, Dave saves $491 annually (0.15 x $3,723). If Dave holds the property for ten years and then sells it, his ten years’ worth of depreciation will have saved him $4,910, a solid savings indeed.

But what Dave doesn’t realize, likely because Dave didn’t consult with a real estate savvy accountant, is that Dave has to repay the total depreciation taken at a 25% rate. The total amount of depreciation Dave took over ten years was $32,730, meaning his recapture taxes amount to $8,183. Annual depreciation actually costs Dave $3,273.

Depreciation Recap 1

The Taxpayer in the 25% Bracket

Dave buys a single family rental for $100,000 and determines that his improvement ratio is 90%. Therefore, his improvements are valued at $90,000 (0.90 x $100,000) and will be his cost basis for depreciation. Dave’s annual depreciation will be $3,723 ($90,000/27.5).

Assuming that his annual depreciation brings his Net Operating Income (NOI) to $0.00 each year, Dave saves $818 annually (0.25 x $3,723). If Dave holds the property for ten years and then sells it, his ten years’ worth of depreciation will have saved him $8,183.

The total amount of depreciation Dave took over ten years was $32,730, meaning at a 25% rate, his recapture taxes amount to $8,183, which is a net $0 savings. Because Dave consulted with a real estate savvy accountant, Dave knew he would owe nothing in depreciation recapture taxes and was essentially getting an interest free loan on his money.

Depreciation Recap 2

The Taxpayer in the 28% Bracket

Dave buys a single family rental for $100,000 and determines that his improvement ratio is 90%. Therefore, his improvements are valued at $90,000 (0.90 x $100,000) and will be his cost basis for depreciation. Dave’s annual depreciation will be $3,723 ($90,000/27.5).

Assuming that his annual depreciation brings his Net Operating Income (NOI) to $0.00 each year, Dave saves $916 annually (0.28 x $3,723). If Dave holds the property for ten years and then sells it, his ten years’ worth of depreciation will have saved him $9,164.

The total amount of depreciation Dave took over ten years was $32,730, meaning at a 25% rate, his recapture taxes amount to $8,183, which amount to a savings of $982. Basically, the IRS loves Dave so much they decided to pay him a premium for the money they were lending him over the past ten years. And who said the IRS doesn’t care about us?!

Depreciation Recap 3

We Can Make This More Complicated

Due to inflation, the real value of your annual savings will diminish. So in order to increase the accuracy of our model, to “break even” in respect to inflation, you will need to account for the reinvestment of your savings from depreciation at somewhere around a 2.5% annual rate of return.

Additionally, we can break the model out on a monthly basis rather than an annual basis to gain a clearer picture of what is actually going on. We can model what would happen if we reinvest our annual savings into various investment vehicles over the hold period to develop a strategy that makes sense and best utilizes depreciation savings. But that’s all beyond the scope of this article.

Moral of the Depreciation Story

Being in a low tax bracket actually hurts the taxpayer in respect to depreciation expense. Fifteen percent Dave should have tried to minimize his annual depreciation expense, which really boils down to how much of the purchase price he allocates to improvements vs. land. If Dave’s research could have supported a higher land valuation, he would have been better off to go that route.

This can be a double edged sword, though. If Dave’s rentals push him into the 25% tax bracket, Dave will then want to take more depreciation, as seen in the next scenario.

On the other end of the spectrum, 28% Dave fares quite well in respect to depreciation and should try to utilize the highest improvement ratio he can support to shelter even more of his income per month. Since 28% Dave only pays the IRS back at a 25% rate, he will come out on top.

And of course 25% Dave is just excited to get an interest free loan. He thought lenders did away with that years ago.

Avoiding Depreciation Recapture Taxes

There are three good methods of avoiding depreciation recapture taxes.

The first option is to utilize a 1031 exchange. Doing so will allow you to defer paying depreciation recapture taxes, as a 1031 exchange allows you to roll the depreciation into the next property. The downside here is that you are merely deferring your depreciation recapture tax liability and will have to pay the recapture taxes upon the sale of the exchanged property at some point in the future.

The second option is to never sell your properties and pass them on to your heirs. When your heirs inherit your investment property, they receive a “stepped-up basis” equal to market value at the date of death, or if they elect this option, the market value six months after the date of death. This means that your heirs will not have to pay your depreciation recapture taxes or capital gains from your original purchase price.

To illustrate, let’s assume you pass on a fully depreciated property to your heirs. Over the years, you benefitted from $90k of depreciation, and if you would have sold, you would have owed $22,500 in depreciation recapture taxes. Due to the stepped-up basis your heirs receive, that depreciation is wiped clean, and their cost basis will be the fair market value at the date of death. Even better, if it’s still a rental, they can begin depreciating it all over again.

The third option (which is not so popular) is to sell the property at a loss. Gains are calculated by subtracting the property’s adjusted basis from the selling price. Adjusted basis generally means original purchase price plus improvements, less depreciation and amortization.

So if you bought a property for $100,000 and you have taken $5,000 worth of depreciation, your adjusted basis is $95,000. If you sell the property for $95,000, you will have a $0 gain and will not have to pay recapture taxes on that $5,000 of depreciation.

There are many other ways to utilize tax deferred strategies to avoid depreciation recapture taxes and capital gain taxes, but can be complicated to explain and so are beyond the scope of this article. The important thing to note is that something as small as depreciation can have lasting impacts on your bottom line and is critically important to plan for in your overall investment strategy.

From: Here

Tax Deferral Is Millennials’ Ticket To An Awesome Retirement

It may be hard for someone in their twenties or early thirties to start thinking about retiring, especially when there is so much interesting stuff to check out on Facebook, Instagram, or Twitter; but this is exactly the time that a Millennial should start preparing for retirement if one wants to have the chance to nail retirement without having to save a lot of money each year. Listen up, Millennials (or Generation Y, if you prefer): One Direction may sing “Live While You’re Young”, but if you started saving for retirement while you are young, then you can chill when you’re old.

retirement

The foundation of retirement investing is based off the concept of tax deferral. Tax deferral means that you can postpone taxes on any earnings you make on the money in your tax-deferred accounts. That means your money is growing each year without having to remove any funds to pay tax. For example, if you contributed $2,000 to a Traditional IRA each year for 10 years and averaged a 7% annual rate of return, assuming a 25% income tax rate, your Traditional IRA would be worth $31,291, whereas if you invested the funds personally, you would have just $23,468. Now, imagine that instead of contributing over 10 years, you contributed over 30 years. Assuming the same facts, your Traditional IRA would be worth $244,692 versus just $183,519. Pretty impressive numbers for just saving around $5 a day. If a Traditional IRA was used, you would eventually have to pay the taxes on the income deferred. But here’s the good news. You may be in a lower tax bracket in retirement, so the taxes you pay will be less than if you had paid them during your working years, and you only pay tax on the amount you withdraw from your tax-deferred accounts. The rest of the money in your tax-deferred account continues to grow tax-deferred—and compounding interest continues to work its magic over time. Of course, you could always open a Roth IRA, assuming you satisfied the income limitations, and all your income and gains would be tax-free, assuming you were over the age of 59 ½ when you took a Roth IRA distribution and the Roth IRA had been open at least 5 years.

The thing with tax deferral is that, generally, the earlier you start, the greater the tax deferral power will be. This is exactly why today is a perfect time for Millennials to start saving for retirement and kick-start their tax deferral clock. Of course, it is never too late to start saving for retirement, which bolds well for Generation X and baby boomers, but Millennials are at the perfect age to take advantage of the amazing power of tax deferral. Much has been made of the enormous impact that student loans and a soft job market has had on Millennials, and how it has hurt their ability to save for retirement. This is all true, but the power of tax deferral can help you retire in style by just saving $5 a day – that’s one less Grande Cappuccino at Starbucks each day. Not a huge sacrifice for potentially having hundreds of thousands of dollars when you retire. They key is starting early, which gives the Millennials a huge advantage over Generation X and the baby boomers. Take a look.

Let’s assume that Dylan is 25 years old and saves $5 a day or $1,825 a year, which he contributes to a Roth IRA. Let’s also assume that Dylan was able to save $1,825 a year until he reached the age of 70. Not a very unrealistic assumption. Let’s also assume that Dylan was able to average 7% annually on his investments, which is actually below the average S&P 500 return since its inception through 2014, which is close to 10%. Let’s further assume that the tax rate stayed static at 25%. Based on the facts, Dylan would have $557,997 in his Roth IRA at age 70, versus just $419,498 had he made the investments personally.

Millennial-Retirement

Now let’s take Susan, who is 45 years old, and has not yet started saving for retirement. If she was able to contribute $5,000 a year to a Roth IRA until she reached the age of 70, then, assuming the same 7% rate of return as Dylan and the same 25% tax rate, Susan would have $338,382 in her Roth IRA at age 70, but only $253,787 if she made the investments personally.

As you can see, from a retirement standpoint, Dylan is much better off than Susan because he started contributing at a young age. Dylan’s Roth IRA contributions equaled $82,125, whereas Susan’s contributions equaled $125,000; yet, because her Roth IRA funds has less tax deferral power behind it, her Roth IRA was close to $219,000 less than Dylan’s. Now, even if Susan earned a 9% rate of return on her investments instead of 7%, that would only increase Susan’s Roth IRA to $461,620, still almost $100,00 less than Dylan’s.

The Millenniums or Generation Y folks are certainly the most savvy and well informed generation ever, but if they just added the concept of “tax deferral” to their vocabulary to go along with Tweet, Face-time, or photobomb, they could also end up being the richest generation.

From: Forbes