Think of your rental property as a money machine that produces four financial benefits: Cash Flow, Principal Reduction, Tax Savings and Appreciation.
1. CASH FLOW: Once you collect the rent then pay your operating expenses and mortgage, there ought to be some income left over.
2. PRINCIPAL REDUCTION: The loan is paid down with rent collected from tenants. The tenants are essentially buying the property for you, the owner.
3. INCOME TAX SAVINGS: Assume you buy a rental property that generates $1,000 in cash flow this year. Is that taxable? Yes, the money came from your tenants. The property also produces $500 of principal reduction this year. Is this taxable? Yes, this money also came from your tenants. So your first two benefits total $1,500.
Now here's the good news: for tax purposes, these benefits can be sheltered by depreciation. Depreciation is a "non-cash" deduction (it's also known as cost recovery). The tax rules allow owners of rental property to depreciate their cost over a number of years. The specific number of years depends on how the cost is allocated.
Don’t be one of the typical investors who merely allocate their cost between land and building. That’s a costly mistake – you’ll pay more tax than necessary.
Instead, be sure to allocate your cost among these four categories: land, personal property, building and land improvements. This is called “bifurcation” which means to separate. By dividing your cost into four distinct categories, rather than two, you will greatly increase your depreciation deduction.
Each category is depreciated over a different number of years:
| Land | Not Depreciable |
Building | 27.5 years for a residential building 39 years for a non-residential building |
Personal Property (appliances, carpet, furniture, etc.) | 5 years in a residential rental property |
Land Improvements (parking lot, landscaping, fence, etc.) | 15 years |
Returning to the example, let's assume your total depreciation for the year is $5,000. Every dollar of depreciation shelters a dollar of income, starting with income from the property. So, the depreciation first shelters the $1,000 cash flow plus the $500 principal reduction. They're completely tax sheltered. And you've still got $3,500 of unused depreciation left over.
This leftover depreciation is reported as a "loss" for income tax purposes. For most people (subject to the Passive Loss Rules) this loss can be used to shelter income from their job or other sources, resulting in tax savings. That's the third benefit. The tax savings are in addition to the tax-sheltered cash flow and principal reduction. Not bad!
4. APPRECIATION: The fourth financial benefit of owning investment real estate is appreciation (or increase in value). We all know someone who owns a property that's worth a lot more than they paid for it years ago.
FAQ: How do I know the cost of the four categories when I bifurcate?
There are several possible ways to make these allocations. They include:
• Use the property tax assessor's ratio for land and building
• Make an itemized list of the personal property and of the land improvements
• Have an appraisal done
• Have a cost segregation study done by an engineering firm
• Or, best of all, negotiate each of these items on the purchase contract. That's what many experienced investors do. These costs are important to both the buyer and the seller. From the buyer’s standpoint, the categories are depreciated over different periods: land (not depreciated), personal property (5 years), building (27.5 or 39 years) and land improvements (15 years).
And from the seller’s standpoint, each of the categories is taxed differently upon sale.
FAQ: I’ve invested for years and never heard of land improvements. What are they?
If you own rental property be sure to depreciate your land improvements (driveways, parking lots, fences, landscaping, etc.) separately from the building. Land improvements are depreciated over 15 years as opposed to a building's 27.5 or 39 year schedule. Most people don't even know about land improvements and miss out on this important deduction.
So, to summarize: when calculating your depreciation deductions do not be the typical investor who merely allocates for land and building. Instead, put more money in your pocket by becoming a lean mean bifurcating machine by allocating land, building, personal property and land improvements.
Disclaimer
This material is designed to provide information in regard to the subject matter covered. It is understood that Tom Lundstedt, is not engaged in rendering legal, accounting or other professional services. Everyone's situation is unique, so – before you, or your clients take any real world action – be sure to check with the proper professionals.