Depreciation And 2 Common Mistakes

[happyardy 0]

Steps to take depreciation

1. Break out the value of land, separate from the structure. Remember, land is not depreciable.

2. Break out the value of personal property items within your building. Personal property items are depreciated over a shorter life – typically ranging from 7 to 15 years.

3. The value of the structure is the total price less land less personal property. For residential rental properties – 27.5 years and for commercial properties – 39 years.

4. The depreciation for the real and personal property is then subtracted from your operating income for the property. (Operating income means that you have deducted the costs of the property –such as mortgage interest, property tax, insurance, homeowner’s dues, utilities, repairs, as well as your business expenses.)

 

 

Common Mistakes:

1) The step that many taxpayers miss is number 2 above. They forget to separate the value of the personal property for depreciation purposes. If you have missed, there are ways to catch up past accelerated depreciation(form 3115).

 

2) Another mistake is much more potentially damaging. Some taxpayers make the mistake of not deducting depreciation on their investment property. If you have made this mistake, correct it immediately by filing to take the past depreciation with your current tax return. If you don’t take depreciation when you should, IRS will assume that you took it anyway. You will have to pay tax on the recaptured depreciation even is there is nothing to recapture !

 

Warning : When you sell your income property, you will have to add back the depreciation, whether you took the deduction or not ! So it doesn’t make any sense to miss out on taking depreciation when you own the income property.

[<Steve> 82]

Good advise happyardy need to keep this in mind when tax season comes up.

 

 

Warning : When you sell your income property, you will have to add back the depreciation, whether you took the deduction or not ! So it doesn’t make any sense to miss out on taking depreciation when you own the income property.

 

I assume when you sell, and one is not doing a 1031, the past depreciation taken is added to the profit made and taxed as capital gains?

[happyardy 0]

Good advise happyardy need to keep this in mind when tax season comes up.

 

 

Warning : When you sell your income property, you will have to add back the depreciation, whether you took the deduction or not ! So it doesn’t make any sense to miss out on taking depreciation when you own the income property.

 

I assume when you sell, and one is not doing a 1031, the past depreciation taken is added to the profit made and taxed as capital gains?

<{POST_SNAPBACK}>

 

 

Steve,

I have done some research and am posting the findings. Dave, please correct me if I am wrong in my explanation to Steve.

 

Here it is.

If you decide not to do a 1031 exchange, then whatever depreciation is recaptured would be taxed at the depreciation recapture tax rate and if you have made profit on the deal(defn of profit : sold it for more than the original cost of the property) then for that portion you would be taxed at capital gains tax rate.

These are 2 different rates.

 

So how do I avoid paying tax on the gain ?

After you’ve determined how much gain you will have to pay on the sale of your investment property, you might make the decision that you don’t want to pay all that tax right now. There are some techniques available to postpone(or avoid) tax such as:

a)like-kind exchange(1031 exchange)

b)charitable remainder trust

c)installment sale, or

d)incomplete contract for sale.

 

Before you do a 1031 exchange:

The idea of getting money for a sale and not paying immediate tax is appealing to many people. However, there are some things to consider before you begin a like-kind exchange.

a)Consider the current capital gains rate. If your property would fall under the low 18%(or even lower 8%) tax rate, it might be advisable to simply pay the tax.

 

b)Consider the depreciation on the new property. You will roll over your basis into the new property. This means that your depreciation possibility will be limited by this rolled-over basis. For example, assume that you are exchanging a property currently worth $4 million (with a basis of only $1 million) into a property worth $6 million. You only have a total basis now of $3 million (the rolled-over $1 million + the difference between the value of $4 million and $6 million). As your investments mature (and the depreciation adds up), your basis will continue to diminish. At some point, like-kind exchanges might not make tax sense since you will lose the ability to deduct the phantom depreciation loss.

 

c)Consider the requirements of the like-kind exchange. There are very specific rules for a proper 1031 exchange. This is a very easy test to fail. These restrictions may make it difficult for you to enact the like-kind exchange.

 

d)Consider the cost of the like-kind exchange. If you don’t have much gain that you are deferring, the cost may not justify going through the steps for a small savings now.

 

e)Finally, make sure you have a good team to help you with this tricky transaction. It’s an easy transaction to do wrong.

 

 

Getting money out of a 1031

 

You are required to roll over all of the cash you might receive from a 1031, as well as the basis. In other words, if you have a property with a large amount of equity, you are required to roll that equity into the next property. It might seem like a good idea, then, to take out a loan on the property just before you transfer. Unfortunately, the rules of the 1031 exchange say you can’t do that.

But what you can do is take out a loan on the property you received. In other words, do the 1031 exchange, get the new property, and then refinance.

This is 1 loophole that will allow you to get the cash from the 1031 exchange.

 

- Ardy

[<Steve> 82]

Excellent. Thank you Ardy. I have definitely learned from your post here!

 

<Steve>

[Dave T 0]

I assume when you sell, and one is not doing a 1031, the past depreciation taken is added to the profit made and taxed as capital gains?

 

Steve,

 

Depreciation is an adjustment to basis. Buy the property for $100K, take $20K in depreciation during your holding period, and your adjusted basis (the book value) of the property is now $80K after the adjustment for depreciation. The difference between your adjusted basis and your sale price is your taxable capital gain.

 

Depreciation taken before May 1997, behaves exactly this way. The difference between your adjusted basis and your sale price is your taxable capital gain at whatever tax rate (5% or 15%) applies to your tax bracket. The 8% and 18% rates were set aside when the long term capital gains rates were reduced to 5% and 15% in 2003.

 

Since May 1997, the portion of your taxable capital gain attributed to depreciation taken (or allowable depreciation that should have been taken) after May 6, 1997 is recaptured at a 25% tax rate, while the rest of the capital gain that exceeds your adjusted basis is taxed at your applicable capital gains tax rate.

 

I know you didn't really ask about an exchange, but since happyardy brought it up, here is some clarification.

 

If you are doing a 1031 exchange, the adjusted basis in your relinquished property becomes the cost basis in your replacement property and the depreciation schedule of your relinquished property migrates to your replacement property. Let's call this adjusted basis in your replacement property the OLD BASIS. For example, I have an adjusted basis in my relinquished property of $37K and 17.5 years left on my original 27.5 year depreciation schedule. When this OLD BASIS becomes the basis in my replacement property, I continue depreciating this basis over the 17.5 years I have left on the depreciation schedule.

 

Often we replace our relinquished property with a more expensive replacement property and bring additional debt or cash to the settlement table to complete the replacement property acquisition. The amount of new debt or cash we contribute to the exchange increases the cost basis in our replacement property. Let's call this component of the cost basis in the replacement property our NEW BASIS. The NEW BASIS in our replacement property is depreciated on a brand new depreciation schedule. If our property is residential rental property, then the NEW BASIS begins a 27.5 year depreciation schedule.

 

To continue with the previous example, if I contribute $50K to the exchange to complete the acquisition of the replacement property, then the replacement property cost basis will have two components -- an OLD BASIS of $37K with 17.5 years of remaining depreciation, and a NEW BASIS of $50K to be depreciated over the next 27.5 years. Each basis component will be a separate asset in your schedule of depreciable assets for that property.

 

I don't accept as a generality, that "At some point, like-kind exchanges might not make tax sense since you will lose the ability to deduct the phantom depreciation loss." The purpose of the exchange is to defer capital gains taxes. If the taxes (to include depreciation recapture) are greater than the cost of the exchange, then the exchange is usually advantageous in spite of a minimal amount in OLD BASIS migrated to the replacement property.

[Cassidy.West 0]

Keep in mind that asset separation for segmenting deductions (accelerated depreciation) and 1031's don't really go hand in hand. At least that's what I think. Someone correct me if I am wrong here.

[Dave T 0]

Keep in mind that asset separation for segmenting deductions (accelerated depreciation) and 1031's don't really go hand in hand. At least that's what I think. Someone correct me if I am wrong here.

 

If you are saying that you can't do both, then I think you are wrong. For example, after I completed my last 1031 exchange, I segregated the personal property from the replacement property structure and depreciated each asset class accordingly.

[randian 0]

If you are saying that you can't do both, then I think you are wrong. For example, after I completed my last 1031 exchange, I segregated the personal property from the replacement property structure and depreciated each asset class accordingly.

The problem is that you can't 1031 your personal property into new real property when you sell. It's not like kind. If you have significant personal property that you've depreciated you'll have immediate recapture when you sell, possibly costing thousands in tax at that time. Worse, if I recall correctly recapture on personal property is taxed at your full marginal rate.

[-Tony- 0]

I have been known to be wrong once but, unless you make over 250k (500k if married) you pay no tax.....

[randian 0]

I have been known to be wrong once but, unless you make over 250k (500k if married) you pay no tax.....

That's only for your personal residence, which you also can't depreciate.

[-Tony- 0]

The problem is that you can't 1031 your personal property into new real property when you sell. It's not like kind. If you have significant personal property that you've depreciated you'll have immediate recapture when you sell, possibly costing thousands in tax at that time. Worse, if I recall correctly recapture on personal property is taxed at your full marginal rate.

 

That's only for your personal residence, which you also can't depreciate.

 

Sure did sound like that's what you were talking about. But hey, I don't do my own taxes I have people (no not them) well a person.

[randian 0]

The problem is that you can't 1031 your personal property into new real property when you sell. It's not like kind. If you have significant personal property that you've depreciated you'll have immediate recapture when you sell, possibly costing thousands in tax at that time. Worse, if I recall correctly recapture on personal property is taxed at your full marginal rate.

 

That's only for your personal residence, which you also can't depreciate.

 

Sure did sound like that's what you were talking about. But hey, I don't do my own taxes I have people (no not them) well a person.

Since the title of this thread includes the word "depreciation" I thought this thread was by definition not about personal residences. Did I miss a change of topic?