Let’s put some money back in our pocket

Yes I am going to write a newsletter about taxes. I get excited about deductions and tax law because it is the lever investors can use to make more margin, save more, and thus grow more wealth faster. Real Estate is especially tax sensitive, so if you ignore the benefits available to you in the tax law, you are leaving a lot of money on the table when it comes to real estate investing. I’m sure I’ve lost most of you by now, but if you are excited by this then you are my people. Let’s go make some margin…

I am certainly on the OCD spectrum. I like right angles and complete spreadsheets. Empty cells that shouldn’t be are like a splinter in my mind. So at the end of every year I like to line up all of my playing cards and see where I can reduce my taxable income. First off, I am not an accountant, so the strategies I share in this article are just that. Everyone’s situation is different so something that works for me may not work for you. However, they can be good questions for your accountant when you are finishing up your taxes for the year.

Basics

The most common deductions are your interest payments on any property as well as property tax payments on property you own. Paying your brother’s property taxes doesn’t count. You can also deduct 1/27th (there is a 0.5 in there but it breaks all rules of grammar) of the value of any rental property, but only the value of the building, not the land. Repairs and maintenance are also deductible perhaps in the year they were made, ask your accountant. If you hold your property in a business entity you can also deduct any utilities you pay on that property as well. I suspect that most readers of this newsletter will know the above by heart already. Nothing to see here, let’s move along.

Accelerated Depreciation on Single Family Houses

I am going to share a strategy I am currently using in my building business. It can apply to remodels too, but it really shines with new construction. It turns out you can get accelerated depreciation on single family rentals similarly to how you can with multi-family or commercial properties. You have to engage a specialist that is a cross between an engineering firm and an accounting firm that can do a cost segregation analysis on your project. Many of them are just formulaic. You punch in your address and purchase price, they divide by three and charge you $500. While this may actually fly with many accountants it rubs me the wrong way because no one did any work with these automated systems.

However the IRS is fully of lazy humans like the rest of us and if the schedule is within the normal range, they usually don’t ask too many questions. As long as the vendor is willing to go to bat for you if the IRS comes calling, you should be fine. So those vendors probably have a pretty good track record avoiding the IRS simply by dividing by three.

The magic of accelerated depreciation is that you can depreciate mechanical improvements (plumbing, electrical, HVAC) and permanent fixtures like pools, fences, and walls at an increased rate. This applies to new construction, or if you do a remodel on a property that you keep and rent.

Example. You build a property to rent instead of sell. As part of the development you add an expensive wall and a pool. Using a qualified vendor you can depreciate the mechanical expenses and land improvements over five years instead of twenty-seven and a half. Lets use an example of building a house for $300,000. $50,000 of that budget was for mechanical elements like plumbing, electrical, and HVAC. An additional $20,000 was spent on a pool and $10,000 on a fence for a total spend of $330,000. A standard deduction would be over 27.5 years $330,000/27.5 = $12,000 in year one.

In the example above you could depreciate $80,000 of the total spend ($50,000 mechanical expense, $20,000 pool, $10,000 fence) in 5 years which would be 1/5 of $80,000 plus 1/27.5 of $250,000 which is $25,090, more than double! If your tax bracket is 28%, that is and additional $3,665 in your pocket every year for 5 years. After year five you are back to the normal deductions and on a smaller amount, but that extra in year one through five helps a lot. So from an efficiency point of view you would want to hold the property for at least 5 years before refinancing or doing a 1031 exchange.

You can do the same thing with a fix and hold project, but the math is more straight forward and the portion of the expenses is smaller most of the time because you aren’t replacing all of the mechanical components. With a remodel that you keep to rent your remodeling expenses are deducted in the standard way over 27.5 years. However if you did substantial mechanical work you might be able to qualify for more accelerated depreciation.

The numbers for the example above are certainly too small for most builds here in Austin, however the money saved as a ratio is fantastic especially if you are using a smart amount of leverage.

Again your situation will vary, so think of this as a tool not a blanket recommendation.