• What a Real Estate Investor should know about Depreciation (Part 2)

    This two-part series is an educational material on Real Estate Depreciation and how it can benefit us as Real Estate Investors.  See Part 1 and Part 2 here.

    How to take advantage of Depreciation Tax Savings

    Now the action steps. How exactly can you use depreciation to save money? Or more appropriately, what do I need to do in order to save money?

    It depends on how hands-on you would like to be in this accounting game.

    1. The Hands-On Crowd

    If you like to do it yourself, you will need to learn the various rules. IRS publishes various articles (Publications 946 and 527) to teach you how to do the calculation.

    I read these articles for research purposes and notice these few things:

    1. They are written in somewhat layman’s terms. (I am not an accountant and was still able to understand.). The articles also have quite decent examples.
    2. Major rules don’t change that often. (I was comparing the 1996 version and the 2014 version and major items are similar. For example, residential buildings are still depreciated on a 27.5 year schedule. Some small changes appear here-and-there. For example, cooking stoves are now on a 5 year instead of 7 year schedule.)

    Based on what you learn, you will then have to do what a bookkeeper or an accountant does. Keeping track of the asset accounts, depreciation schedule etc. etc. (lots of accounting-speak). These are standard accounting stuff and standard accounting books will teach you how to set up the spreadsheets to keep track.

    2. The Not-Hands-On Crowd

    Just like most things, you can always hire extra help for virtually anything in this business. Depreciation calculation is no different. Even though I learned how to do the calculation, I no longer do them myself either. What you will have to provide to the accountant are the receipts of the major purchases. Personally, to make things easier for my accountant (and less costly to me), I like to summarize the purchases into one table. It does not need to be too fancy. Just Date, Item, and Amount shall be sufficient. Like this:

     

    Date Item Amount
    Feb-01 Water Heater $850
    Sep-06 Stoves $500
    Nov-08 New Fridges $600

     

    You don’t need a real-estate specific accountant to do this either, as depreciation is used in many more industries aside from real estate. Also, unless you have a super-large portfolio of properties, these calculations are usually a once-a-year exercise. The accountant usually won’t charge you too much for this.

    P.S. A little bit off-tangent here. There is a small benefit to find a real-estate specific accountant, as opposed to doing it yourself or getting a general accountant. That is because he/she is more likely to know about some tips to save on taxes specific to real estate. From time to time, there can be one-off tax savings that most people aren’t aware of (e.g. the special tax credit for energy efficient improvement to house in 2013). A real estate accountant is more likely to know that than a general accountant. Ever better, try to find an accountant who owns investment properties on the side (so he /she is more vested into finding out new tips and tricks).

    3. Both Crowds

    Whether or not you decide to do it yourself, there is one IMPORTANT lesson to remember. Have a mindset that Tax Guys (IRS) will come back to ask for evidences. What that means to you is that you will need to keep the receipts (or renovation invoices) from your contractors for the improvements that you made to the house.

    The most important receipts are:

    • HUD-1 / Purchase-Sale Contract (the one that spells out purchase price)
    • Property Tax Record at time of purchase (spells out land value and building value)
    • Major home improvement purchases (e.g. water heater, stove)
    • Renovation invoices (if you hired a contractor to do major work)

    Concept is simple. If you claim you put a new water heater in, you need to show proof (ie. receipts). At the end of the day, these receipts are your tickets to money.

    Big Picture

    We have just learned in detail how depreciation works and why we do it in the first place. Let’s take a step back and see how it fits into our business overall.

    What we are doing here is use a legal accounting mechanism (depreciation) to save money in order to improve our profit. There are three points I would like to bring up, and these will be equally applicable to any other tax saving strategies that you may be considering to deploy.

    1. Not all things are objective. Interpret to your favor.

    Laws are not written as mathematically proofs. Laws are written in words, and subject to interpretation. Of course, different people have different interpretations. So how to deal with this uncertainty?

    Here is my stance: When in doubt, I always aim at interpreting the rules to my favor. At the same time, I always prepare for a possible future challenge from the tax department by coming up with a justification to defend my point beforehand. In a good case, I will get what I want. In a bad case, the tax department will just force their way (same as you take a more conservative approach and not challenging it). Don’t be afraid to take an aggressive stance.

    Remember: You may not always get what you want, but you will certainly NOT get it if you never ask!

    2. Law of Diminishing Return

    An example will best explain the Law of Diminishing Return. Say you hire someone to mow a big lawn, which will take him 3 hours to complete it.

    You hire two people, and the time it takes to complete will likely cut down in half.

    You hire 10 people, and most likely it will take more than 10% of the original three hours (because workers will be getting into each other’s way).

    You hire 500 people, and you will never be able to finish the job. (they will just all be confused!)

    You expect good results by putting more effort at the beginning. After some point, simply add more resources to the same project will not help achieving better results, or may even be worse.

    In our case, you might find it very beneficial for the first few hours that you spent by learning the basics, gathering receipts, compiling data, talking to accountants etc. At some point, with the big items taken care of, spending much more time in there will not yield the same amount of extra savings.

    There is no reason to spend hours and hours of your accountant’s time (even worse, your time) to figure out how to save a couple dimes here and there.

    Those hours are much more effective if spent on finding more deals, securing funding, relaxing on a beach, or mingling with your friends. How you decide to spend it is entirely up to you.

    Use your own judgment.

    3. Treat it like a business. And (good) business is supposed to make $$.

    I know some people dislike IRS up to the point where they see it as an unforgiveable sin to pay any tax. They will always come up with whatever imaginative ways to turn their business into a loss, at least on paper.

    I certainly agree that no one should pay more tax than he or she is supposed to. But it does not necessarily mean never pay any tax. I think those people who never pay any tax ever simply don’t get their priorities right.

    Let’s review that. What’s the top priority for operating a business? Even looking entirely from a money standpoint, your goal is to maximize the after-tax profit. Paying less tax is simply a mean, NOT an end, to achieve that.

    For example, it is better to make $10, pay $2 tax (so net $8 profit) than to make $5 and pay no tax. It sounds obvious, but trust me, some people do forgo an opportunity to make the extra money just to make sure they don’t have to pay any tax.

    …which means you should pay tax

    Actually, there is an extra benefit to pay tax from time to time.

    A business that pays taxes is more likely to fall out of the IRS’s radar than a business that pays no tax, and that’s to your benefit.

    To clarify my point, I am not saying that we should be scared of potential IRS queries and avoid it at all costs. Rather, I simply see very little value (e.g. make more money) for any conversations with IRS. It’s not that they will come to my door and say, “Thank you for filing tax perfectly this year. Here is $2,000 as our appreciation.” (Nothing against the IRS folks. I am sure there are a lot of great people working there. It’s just their job nature and their impact to our business.)

    Talking to Real Estate Agents, Wholesalers, Investors, Lawyers, Accountants, Contractors, Property Managers, Tenants, (any other Team Members?), I see the added value. Talking to IRS? Not so much.

    So why you would even want to invite them to your life?

    I don’t know the exact metric how it will trigger an audit from IRS (ie. tax department looking at your business’ fiance), but one thing I know for certain: IRS is looking for people that smell fishy.

    All business (excluding non-profits) has the goal to make money, so why would anyone in their right mind choose to run an ever-losing-money business? It is okay to lose money in first couple of years, and from time to time thereafter. Losing 10 years in a row? Give me a break! Either the company’s financial is fishy, or simply it’s not the right business to be in. Either way, you don’t want to be in there.

    Going back to the previous point. How would you want to spend your time and money? Finding deals, partners and all those cool things? Or responding constant inquiries from IRS?

    Summary

    This article covers most things that you should know about Depreciation (except for how to do the calculations =P ). Since this page is quite long (almost 4,000 words!), I will summarize the key points here:

    Key Points:

    • Depreciation helps you save money every year by reducing the amount of tax needed to pay, if needed to pay at all.
    • Depreciation helps mostly buy-and-hold investors.
    • Save your receipts as proof. Put together a summary sheet tabulating important information. You can hire an accountant to do calculation.
    • Most work can be done by a typical (non-real estate specific) accountant. Real estate accountant can help you with special tax-saving expenses.
    • Depreciation is an important subject to you. Just don’t go crazy with it. Use common sense.

What do you think?

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