Costly Mistakes Every Real Estate Investor Should Avoid
In part one of this article, I discussed the complexity of the Tax Code regarding real estate and identified three costly mistakes that are common among real estate investors. Now, a couple more tax tips.
Mistake #4: Not Understanding the Difference between Repairs and Improvements
One of the most important decisions you’ll make as you own your properties involves distinguishing between “repairs” and “improvements.” Repairs are deductible immediately as you make them. Improvements are depreciable over time. It usually makes sense to characterize fix-ups as repairs so you can deduct them faster.
In general, the repair deduction is about 3000 percent more valuable to your current bottom line than an improvement is. A repair is fully deducted now, whereas a capital improvement is taken over a period of 27.5 or 39 years. An improvement costing $27,500 would only allow a current year deduction of $1,000, if using the 27.5 year method.
Defining the terms “repair” and “improvement” seems straightforward enough. Repairs keep your property in good operating condition. They don’t add value and they don’t prolong the property’s use. Examples include painting, plastering, repairing broken windows, and fixing gutters, floors and leaks.
Improvements adapt your property to new uses, add value or prolong its use. Examples include room additions, upgraded appliances, new landscaping, and replacing components like furnaces, roofs and windows.
Tax Tip: For tax purposes you never want to “improve” your rental property and try your best not to remove a tenant (taking the property out of service) while you make “repairs”. By removing a tenant, you not only suffer a loss of cash flow while the property is out of service, but you can trigger something even more serious, the uniform capitalization rules.
Capitalization rules do not allow the expense to be treated as a repair and may require you to capitalize even the interest portion of the expense for the time the property was out of service.
If you must improve the property without it being in service, then do it quickly. Keep it out of service for less than 90 days, so as not to automatically fall under these rules.
Mistake # 5: Not Making the Most of Depreciation
Depreciation is the process of writing off a capital asset, such as a rental property, over a period of time intended to approximate its useful life. The IRS says that residential properties last 27.5 years, whereas nonresidential properties last 39 years.
Good tax planning tells you to accelerate your deductions and defer your income. You can greatly enhance the acceleration of your depreciation deductions if some components of your property could be depreciated using either a 5 year or 15 year depreciation method rather than the 27.5 or 39 year depreciation methods.
Separate out Land Improvements. We all know that land is not depreciable, but what about land improvements? Driveways and sidewalks crack, landscaping needs replacing, and pipes from the house to the street deteriorate over time. You can depreciate land improvements over 15 years. Land improvements include the following:
• Sidewalks, roads, and waterways,
• Drainage facilities and sewers,
• Docks and bridges,
• Fences, landscaping, and shrubbery
Trees and shrubs planted near a new building are generally depreciable. The IRS grants depreciation for the trees and shrubs close to the building because when you tear down the building, you also tear down the trees and shrubs.
However, you may not depreciate the trees and shrubs located away from the building. Those costs are considered part of the cost of land when constructing a new building. They are not depreciable and must be capitalized (added to the cost basis of the land). They give no tax benefit until the property is sold.
Separate out Personal Property. You can break out certain “personal property” and depreciate it separately, such as appliances and equipment. By separating personal property from the building, you are allowed to accelerate the depreciation over as little as 5 years—which gives you far more deduction in the early years that you own your property.
By separating some of the components of a building into depreciable classes, the deduction for some assets can be accelerated. Instead of depreciating an entire building over 39 years, the land improvements can be separated out and depreciated over 15 years (250% faster); the equipment can be separated out and depreciated over 5 years (nearly 800% faster).
A little planning can greatly enhance your current tax benefits. See my next article for part three.
By Randy Roth, EA, CSA, MSFS
The foregoing is intended to provide general information, not specific tax or legal advice. For specific advice you should contact your tax advisor, or you can contact us.
About the Author
Randy Roth is a tax, estate & business consultant. His practice concentrates in the areas of tax preparation and planning for individuals, businesses, estates, trusts and non-profit organizations. He is knowledgeable in real estate matters, including the taxation of real estate, estate issues involving real estate, as well as the business of real estate. He can be reached at his firm, Incompass Tax, Estate & Business Solutions at (916) 974-9393. The office location is: 4600 Roseville Road, Suite 150, Sacramento, CA 95660.