Wednesday, June 20, 2007

Depreciation And Your Rental Property

Yesterday over at my other blog on ActiveRain I authored a post titled How Are Your Current Real Estate Investments Going? To get background for this post it might be wise and go and read that post.


But the gist of the post was that if you've owned the same income property in Kansas City for 7 years or longer you are probably no longer maximizing your returns the way you should be. That in fact;
  1. You are no longer maximizing your leverage
  2. If you are properly bifurcating your depreciation you have already exhausted your personal property portion (with the exception of new personal property added)

Leverage was discussed there. We'll talk about your depreciation here.


Depreciation

Bifurcate is just a $10 word for cost segregation. There are actually 4 ways you can segregate your depreciation on your investment property;
  1. Land (which of course doesn't depreciate)
  2. Personal Property (over 5 years)
  3. Land Improvements (over 15 years)
  4. Building (over 27.5 years)
Most people are probably only utilizing #1 & #4. They are overlooking (or your accountant is) #2 & #3. But if you are maximizing your depreciation you can see that by year 7 you have already exhausted all your beginning personal property depreciation and 1/2 of your land improvements.

Why is that a big deal? Because if you have broken out your costs you will probably find that personal property depreciation accounts for between 40% - 50% of your yearly depreciation total. At least at first.

Now as you change carpet, appliances, lighting fixtures and the like you can start a new 5 year schedule on those items. But about 1/2 of your beginning depreciation number is now gone. It's not coming back.

In addition, you are also 25% of the way through your building depreciation. That investment property that used to give you overall returns of 22%-24% is now generating overall returns of 13%-15%. And it will continue to slide down from there. No matter how much your cash flow continues to build. (Well, there might be exceptions that I haven't seen.)

It could be that you just don't want to change houses or there are sentimental reasons you don't want to exchange or you are just happy with the money you have. But if you are still in the growth phase and you are looking to maximize that Retirement Worth Having, you may wish to consider sitting down with knowledgeable investment real estate agent or tax planner and figure out what to do next.

4 comments:

Benjamin said...

Our company, MR Valuation Consulting LLC, performs cost segregation studies. We save our clients millions of dollars every year. We choose not to use the word "bifurcate" because it means splitting into two, and we split into many more than just two categories. Our engineers can even calculate the portion of the electric system (e.g. panels, wiring, switches, etc.) that is dedicated to kitchen equipment and window air conditioning units, and reclassify it as 5-year property.

-Benjamin Williams

Keith said...

DepreciateEm.com is a free website created by Trexglobal.com that walks you through the asset separation process you are describing. It’s a tool that helps you identify short life assets and values so you can segment your depreciation deductions. I used Depreciate’Em on two properties for 2006 and it saved me over $6,000. It set up my depreciation schedule and it generated an asset report and IRS Form 4562 for my tax return.

Another tool that I’ve found to be very useful is DeferEm.com, which was also created by trexglobal.com. It is an online application for optimizing your 1031 exchange, and it generates an exchange report to accompany IRS Form 8824. DeferEm.com is also one of the best resources I’ve found for being able to understand different elements of 1031 exchanges: like boot, taxable gain, deferred gain.

Tools like these are free to use, so it surprises me that more people do not take advantage of tax saving resources that are available to them (like cost segregation). Like you said, perhaps people “are just happy with the money” they have, but those who aren’t should certainly plan on figuring out what to do next.

Chris Lengquist said...

Keith - I was not aware of that site. Thanks. I'll check it out.

Benjamin - Thanks for the intel.

Hopefully readers will continue to see this post and these comments to decide for themselves. It would appear from the hits this post on depreciation is getting that this is a popular subject.

Keith said...

I read a Forbes.com article that said "if you have an investment property, take it like a sponge and squeeze it." The article was about how small-time landlords can avoid missing out on major tax savings, like depreciation.

It just goes to show that many people lose out on major tax savings, simply because they don't know the rules about rental property, or they are unaware of resources available to them. I learned about Depreciate'Em from this Forbes article: http://www.forbes.com/free_forbes/2007/0604/174.html

I encourage you to check it out.