Love Austin Homes Investing Blog

Do you need to take the depreciation when you rent out the property? I think
I’ve read somewhere that for rental properties if you don’t take the
depreciation, you’ll still be hit by depreciation recapture when you sell.
Is this right?

You don’t have to take the depreciation. I believe I read on the IRS’s web site you will
still be hit by depreciation when selling weather you took it or not. I don’t remember
which publication it was 2-3 years ago, contact an accountant about it.

Thanks,
Mike.

ANSWER

Mike,

The IRS assumes you are taking depreciation all along and charges you back for all of the deprecation (whether you took it or not) when you sell the property.

What this means, for those of you new to depreciation, is that the IRS allows and expects that you will take a tax deduction equal to the acquisition cost of a property divided by 27.5 (years). For example, if you buy a house for $100K, each year you get to depreciate $3636.36 of it’s value, which is a “passive loss” tax deduction. These “losses” are a great benefit of owning rental property, because they offset income and thus reduce your taxes each year.

If you hold the property for 27.5 years, you will have depreciated the entire $100K, and thus you can no longer take depreciation (although you can take more if you have made improvements along the way). If you then sell the property for $200K, you profit IS NOT $200K (sale) minus $100K (purchase) = $100K (profit), as some people believe, but IT IS INSTEAD $200K (sale) minus $0K (the depreciated value) = $200K profit, ALL OF WHICH is taxed, at long-term rates. Yes, that’s what I said, after 27.5 years the IRS assumes you took all the depreciation and assumes that whatever you sell the property for is 100% profit, and taxes it all.

Because you are always going to have to pay taxes on the depreciation at sale, I can’t think of any reason not to take the depreciation each year.

Now, of course if your income is over $125K (in which case your deductions are limited) and/or you don’t have sufficient passive income to offset the deduction, you may say “I don’t need, want, and can’t use the deductions this year”. That may be the case, but you pretty much need to take it anyway, and just roll forward (the deductions/”passive losses” ), on your tax return, any so they can be used in future years.

If you do this, then in the example I gave earlier, you take the $3636.36 deduction each year, but because you can’t offset the deductions, you just keep rolling them forward. After 27.5 years, you still sell the property for $200K, but now you can deduct the $100K of “rolled forward” losses from the last 27.5 years, from the $200K profit, thus reducing your profit from $200K back down to $100K.

Of course in the more likely scenario where you start making increasing amounts of income off of your property, that income can be offset by the rolling losses making the income tax free or tax reduced along the way.

Phill

Does anyone here have a recommendation for a good, experienced small
business CPA? Thank you very much.

ANSWER

Yes,
I use I Jay Arrons 512-451-2800.

Phill

I would like to set up 2 business entities, one for flips and one for long term properties. Can anyone give some advice/insight on how they have done this. Also, any referrals for an accountant and attorney would be appreciated.

Thanks,
Ashley

ANSWER

Ashley,
This is a very complex question. I have paid multiple lawyers and accountants to help me with this. The problem you get into is that the lawyers answer the question in terms of how to limit your liability “Put everything into separate LLCs…blah blah blah”, while the accountants answer the question in terms of how to save on taxes “Don’t use LLC’s because of franchise tax and bookkeeping overhead…blah blah blah”.

To help sort this out, I did go to Adrian Van Zelfden, because he’s a lawyer and accountant (though really an accountant), and he was helpful initially, however, unfortunately he is no longer doing much in real estate, so he basically told me that that there are several better guys in town than him to help set up and do taxes for real estate businesses.

One thing I suggest is that you need to draw up a 5-year plan that says what types of transactions (and how many of each type) you plan to do.

If buying rental properties, consider how these will be bought (subject-to, personally guaranteed loans, business loans), and how these will be held. Things get quite complex if you buy something with an entity and want the entity to get financing. You’ll quickly discover, for example, that an entity will pay 2-3% more for a mortgage and 50% more for insurance, which may make this option uneconomical long term. Buying things in your own name brings about liability issues, which brings up the topic of insurance… and what it covers, and what, no matter what they tell you, it does not cover… You can also move things back and forth into entities, but that raises several other issues.

If flipping properties, consider how many tax returns you want to generate (which are required for some types of entities), and consider the dreaded “IRS dealer” status you risk getting if you do things the wrong way. Oh, and don’t forget employment tax – 15% right off the top, depending again on how you do it all…

Take your 5-year plan and map these transactions into different entities and see what the ramifications are. There is no perfect solution – just tradeoffs between liability protection, cost, tax efficiency, insurance requirements, etc.

Regards,
Phill Grove

Do you ever feel compelled to hold a reno project for a full year so you only have to pay cap gains taxes on the property? Or do you just plow ahead and sell when its finished, incurring taxation as regular income? Anyone have thoughts on this? It appears the difference is so substantial, it’s pushing me towards year long holds, but wondering if there are any problems with this option – other than the fact the market could go down during that time…

Robert

ANSWER

Robert,
Usually the cost of interest payments on the money and/or the real-time value of money (in other words the opportunity to put the money to use on other projects) outweigh the benefits of long-term capital gains vs. short term capital gains (income). I’ve got one huge project that is pushing a year in scope that I may push the close on so that it pushes me over the 1-year mark, but this is just because the project already took 10+ months. If I weren’t right near the 1-year mark anyway, I wouldn’t hold out.

I also consider strategies such as renting a property out and later selling. For sub-$125K ARV renos, I often offer them for sale and for rent, and take whatever comes first. If I rent them, I get long-term financing in place and plan to continue to rent for several years. For >$125K ARV properties, this would usually have negative cash flow, and put my beautiful remodel at risk of being just another used resale down the road, so I don’t bother offering to rent.

Also be aware that depending on how you structure your business and your personal finances, you may be at risk of being classified as a ‘real estate dealer’ by the IRS. I’m getting a little outside of my expertise here, however, my CPA has warned me that this classification would make someone ineligible to claim long-term gains on properties flipped pasted the 1-year mark. You also lose other tax benefits such as the ability to depreciate properties. For this reason, you may want to take steps to avoid this classification.

Phill