How Can I Take Advantage of Depreciation?

[Harry Campbell]

So I rented out my condo last July and I'm starting to look over my tax documents in preparation for filing. I've done a lot of research over the past couple days but to my understanding since I make less than 100k AGI, I can deduct up to 25k in passive losses from my W2 income.

That almost sounds too good to be true though since I'll be close to 75k AGI this year putting me in a marginal tax bracket of 25% fed, 9% state, plus fica/med, etc. I understand I'll have to pay back 25% in depreciation recapture when I sell but still 15 cents on the dollar plus all that time of tax deferral sounds pretty awesome - how did I not know about this haha?

I charge my tenant 1900/mo for rent and my expenses are as following: 550/mo for interest, 300/mo for prop taxes/insurance and 400/mo for HOA. I know the basic formula for calculating depreciation, but I haven't looked into it too much yet. I bought the place for 280k, put in about 10k worth of repairs and redfin tells me the land value is 180k(which seems absurdly high). So depreciation would be 290-180 = 110k. 110k/27.5/12 = 333/mo in depreciation.

So that's 1583/mo in expenses/depreciation which obviously wouldn't create a passive loss since my rent is 1900/mo but I spent $3,500 last year on a new A/C and dishwasher. So I had my place rented for 6 months and made $1902($317*6 months) but after the $3,500 in expenses I lost $1,600 on the property.

In my scenario, wouldn't it make sense to get my depreciation as high as possible since this is a phantom expense. My property will still be cash flowing every month but if I can increase my depreciation/month and get as close to 25k in passive losses I'm guaranteeing myself 15 cents on the dollar plus tax deferral.

Another idea I had: I don't want actual expenses but wouldn't it make sense to do a lot of repairs/fixes while I have the place rented out. For example, if I wanted to put in new floors, new carpet, etc wouldn't these all count as expenses and I would get basically a 40% discount off these expenses(until I hit the 25k limit) since it would be reducing my taxes at my marginal rate.

[Dave Toelkes]

Originally posted by @Harry Campbell:

That's what one of my friends told me to do actually. My county tax assessment lists the same value that's on Redfin. I bought this place as a short sale in 2009 so I know it's gone up 20-30% or more since then. How would I find the land/building value of a nearby comp though? The are some comps in the 350k range that I would like to use and would also be appropriate.

Here is how you use the tax assessor value. You have to look at the entire assessment -- land and improvements. Take the assessed value of the improvements, divided by the total of land and improvements, then multiply by your purchase price. The result is the initial depreciation basis for your property.

For example, you say you purchased for $280K and the tax assessor value of your land is $110K. If the tax assessor's value of the improvements is $330K, then your initial depreciation basis will be 330/440 x 280 = 210K. If you subtract 210K from your purchase price, then you paid 70K for the land. In this example, your cost basis for the land is $70K and can not be depreciated.

Your purchase price, for depreciation purposes, is allocated $70K to land and $210K to depreciable improvements. Now, you say that you also put another $10K into additional improvements. This is added to the depreciation basis for the dwelling structure, giving you a tax basis of $220K for the dwelling structure (in this example) which you can depreciate over the next 27.5 years. As you make additional capital improvements over time, the cost of each improvement is depreciated on a separate 27.5 year schedule.

In this example, $8000 of net income from your rental will be sheltered by depreciation each full year your property is in service as a rental. If the property cash flows, you may never sell it, and then you will never have to pay taxes on the unrecaptured depreciation. Isn't depreciation great?

To extend this example further, you say you have about $650 per month in net cash flow after you pay the recurring costs each month. That amount is sheltered by your depreciation.

What you have not considered yet, are all the other costs of ownership that take money out of your pocket. You will have advertising costs, legal fees, repairs, maintenance/upkeep. n If your landlord tenant law requires you to pay interest on security deposits, then that may come out of pocket. In one state where I have rental property, there is a rental license that I have to purchase each year. Property management fees may also be in your budget if you don't self-manage. Since your depreciation expense has already been used up to cover your expected net cash flow, these costs will create a tax loss for this property. HOA dues, property taxes, and insurance premiums do go up and those cost increases will add to your paper loss. There may be a time when your property is vacant and there is no rent coming in. The excess depreciation that you did not use to offset income also adds to your tax loss. It is not hard to envision a day when you might have $10K or more in tax losses (in spite of your $8K depreciation expense) to use against the $25K passive activity loss allowance.