Maximize Depreciation by Bifurcating
Don’t be a typical, uninformed property investor who, for depreciation purposes, merely divides the cost of the property between land and building. That’s a costly mistake – you’ll pay more tax than necessary. Most rental property includes personal property and land improvements as well as land and building. Let me show you what I mean.
Example #1: Uninformed Investor
Assume you buy an apartment building for a cost of $500,000. Most people divide the $500,000 into two categories: land and building. The most common way to do this is to use the property tax assessor’s ratio for land and building (from the property tax statement). In this case let’s assume the land is 20% of the cost ($100,000) and the building is 80% ($400,000).
The $100,000 land is not depreciated. Referring back to the chart found in the Depreciation section, we see that the $400,000 building, if placed into service in January, qualifies for 3.48% the first year ($13,920) and 3.64% the second year ($14,560) for a two year depreciation total of $28,480.
For the sake of this example, let’s assume you’re in a 35% tax bracket when you combine your federal and state brackets.
Therefore, the $28,480 depreciation shelters $28,480 of your income earned from various sources which means you’ll be able to earn $28,480 without paying income tax on that money. If you would have had to pay income tax on that money you would have had to pay $9,968 ($28,480 X 35% bracket). Not bad.
But hold on. You’re not the typical, uninformed investor. Remember? You’re a lean, mean bifurcating machine who knows the cost should be divided into four, not two, categories.
You’re a lean, mean bifurcating machine who knows the cost should be divided into four, not two, categories.
Example #2: Savvy Investor
Let’s re-do the example by bifurcating for depreciation purposes. Probably the best way to bifurcate is to negotiate the cost of each category on the purchase contract. These costs are important to both the buyer and the seller. From the buyer’s standpoint, the categories are depreciated over different periods: land (not depreciated), personal property in a residential rental (5 years), building (27.5 or 39 years) and land improvements (15 years).
And from the seller’s standpoint, each of the categories is taxed at different rates upon sale.
For our example purposes, assume the personal property (stoves, refrigerators, washers, dryers, carpeting, drapes, etc.) and the land improvements (parking lot, driveway, landscaping, fences, etc.) are each $50,000.
The new calculations would be as follows:
Personal property depreciation is 20% in year one ($10,000) and 32% in year two ($16,000) for a two-year personal property depreciation total of $26,000.
Land improvement depreciation is 5% in year one ($2,500) and 9.5% in year two ($4,750) for a two-year land improvement depreciation total of $7,250.
We’ll continue to use the assessor’s percentage for the land and building. In this example 80% building and 20% land. But wait. The land is now 20% of $400,000, not $500,000. That’s because the personal property and land improvements have nothing to do with the assessor’s ratio. Therefore, remove those items from the total which makes the cost of the land/building $400,000, not $500,000.
Using the assessor’s ratio we get $80,000 for land and $320,000 for building.
The land is not depreciated and the building, if placed into service in January, qualifies for 3.48% the first year ($11,136) and 3.64% the second year ($11,648) for a two year building depreciation total of $22,784.
If you add up the two-year depreciation totals for each category you get $56,034. Therefore, the $56,034 depreciation shelters $56,034 of your income earned from various sources which means you’ll be able to earn $56,034 without paying income tax on that money. Assuming you’re in a 35% tax bracket (combined state and federal), your tax savings are now $19,612!
Look at the power of this! If you depreciate like the typical, unaware investor you save only $9,968. But if you depreciate like a savvy investor, you save $19,612. The difference is $9,644!!
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Tom Lundstedt "Maximize Depreciation by Bifurcating "
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