Strategy question: Depreciate or Expense?

Question

Hi! I've searched around a ton to find a simple answer to this to no avail. Maybe because it's been hard to wade through the flood of information on depreciation and expenses.

I wanted to know the strategy behind whether you should depreciate or expense an asset that could go either way. Does it make the most sense to write off something in the same year only if it helps reduce the current taxable income?

For example: replacing living-room carpeting that costs $1,000.

If I am going to show a loss for the property anyway, does it make more sense to depreciate it? Would it be a waste to expense/writing it off this year?

I think I know the answer, but I am just guessing. I think that I should deduct the expense this year only if it reduces my taxable income. Otherwise, if I'm already showing a loss, it seems like it would make more sense to depreciate it over the five years.

Can someone please help clarify my muddied thinking on this? Thank you!!!

Paul Caputo · Answer

I believe @Scott Davidson is pointing to the passive income rules. Since you're not a real estate professional your rental income is passive income. Losses from passive income activity can only be deducted against passive income. Any excess would be carried forward to the next year. So if you're already showing a loss on your properties that loss will be disallowed this year and go to next year.

Check out https://www.irs.gov/pub/irs-pdf/p925.pdf Publication 925: Passive Activity and At-Risk Rules for more info on that.

The carpet IS tangible personal property (unless it's in the bathroom or something weird that changes it) with accelerated depreciation treatment, but because of the low cost it could be eligible for safe harbor: that depends if you've done anything else that qualifies for safe harbor and have high enough unadjusted cost basis since there are limits. Also safe harbor isn't automatic you have to elect to use it with a statement when filing taxes. Again if you're already showing losses this would be disallowed until next year: if you're still showing losses then it keeps going until you're allowed to take it.

Paul Caputo · Answer

@Tanya Patience It's not what "makes more sense" there are actual rules for what you should do. The Final Tangible Property Regulations give guidance on what to do, but it's best to get a CPA involved since they're gonna be able to help you out here. Your carpet example is technically tangible personal property that should be depreciated over 5 years, but you could be eligible to elect the de minimis safe harbor exemption since it's under $2,500 ($500 if before January 1, 2016 so if it was then it wouldn't qualify) which would allow you to expense it in the current year rather than capitalize and depreciate. But being under $2,500 is not the only requirement, your total safe harbor expenses for the year have to be under $10,000 or 2% of unadjusted cost basis whichever is lower.

Financially it depends on your entire financial picture. Deductions are worth more when you're at a higher tax rate. If you're showing losses on your properties and have significant other income I'd expense as much as possible to lower your overall taxable income further. If you're showing losses on your properties and do not have significant other income then further reducing your taxable income wouldn't do much to help you. You could potentially carry forward those losses into future tax years but there are restrictions on that. A $100 deduction is only worth $15 in tax savings at the 15% tax bracket, but the same $100 deduction is worth $35 in tax savings at the 35% tax bracket. The other thing to consider is depreciation recapture. Expenses are considered costs in the current year so when you sell the property down the road you don't have to repay those deductions. With depreciation you have to repay it upon sale of the property they call that depreciation recapture and it is taxed at a maximum of 25% depending on your marginal tax rate.

I know no one likes this answer, but the truth is ask your CPA there's not really a one size fits all answer here it depends on your individual situation and long term plans. Generally it makes more sense to expense everything you can since you get the full deduction now and don't have to recapture. It gets trickier to know what can and cannot be expensed, and even more so when you factor in personal finances and the impact of these decisions over time.

Tanya Patience · Answer

@Paul Caputo Thank you so much!! I really appreciate you walking through some example situations. And of course, as you say, I know there are rules. But you then also made my point: This carpet could either be listed as tangible personal property that should be depreciated over 5 years but it is also eligible for the de minimis safe harbor exemption since it's under $2,500.

@Scott Davidson I'm not sure what you're asking when you say "Can you take the loss?" I have three rental properties. I am not a real estate professional. The properties at various points are in the red or black, tax wise. I plan to hold onto them for a few years. Thanks for your thoughts.

@Andrew Johnson I was leaning toward depreciating but I'm on the fence re taxable income for this property. What I'm trying to do is actually figure out whether I will have taxable income from the property, and whether taking the expense this year would eliminate that.

Thanks so much Account Closed and everyone.

Account Closed · Answer

You have two questions.

First - Can new carpet be written off as a repair instead of being treated as a capital asset and depreciated?

The answer: Yes, it can.  The IRS is not picky about these things.

Second - Are there any negatives to depreciating the asset instead of expensing it?

The answer: Yes, there is one.  When you sell the property you will be faced with paying tax on your Capital Gains, unless you decide to engage in a Section 1031 Exchange.  And part of your capital gains will be the depreciation you have claimed over the years.  You will be taxed at 25% on this Depreciation Recapture.

I hope this helps.

Michael Lantrip

Scott Davidson · Answer

@Paul Caputo That's exactly what I was alluding to.

Scott Davidson · Answer

There's a lot of misinformation so far in this thread.

https://www.irs.gov/businesses/small-businesses-se...

Read up there on what constitutes a repair vs. depreciation.

As to the strategy of whether to depreciate or expense, the answer is - you guessed it! - it depends.

Can you take the loss? Do you have other passive income? Are you a "real estate professional"? What are your plans for the property? Do you expect taxable income from the property in future years?

All of these answers might affect what would work best in your particular situation.

Brent Coombs · Answer

Maybe there IS wiggle room?:- http://fultonhotelsolutions.com/4-ways-to-sort-out...

Not being an accountant, I dare not be more specific (Sorry about that). Good luck...

CL Ziegler · Answer

Oh, this is basically what I was asking in my new thread a minute ago. I hope @Brent Coombs will weigh in on my thread too. I always felt the owner's discretion played a role how expenses are categorized (such how Tanya presented her question) but got confused when my CPA slammed the door on it saying I have no option other than to depreciate.

Is there wiggle room in the law on this?

Thanks Brent.

Tanya Patience · Answer

Hi @Brent Coombs, unfortunately it doesn't, but thank you for welcoming me and trying to help.

I understand the theory/reasoning behind why something might be considered a capital expenditure. But I also believe that you could make an argument that something, like carpeting, could go either way. I'm trying to understand the numbers and strategy. When would it be more useful for your bottom line to depreciate over time vs. write off in a single year? What are the pain points, so to speak, to look out for if I'm trying to (legally, of course) minimize the amount of tax I pay?

Strategy question: Depreciate or Expense?

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