1.4 Substantially Increase Depreciation Deductions via Componentizing (Cost Segregation Analysis).
Depreciation is your most valuable deduction because it does not require you to expend cash to get the deduction, yet it creates cash flow in your pocket from the deduction’s tax savings.
For example, a $20,000 depreciation deduction reduces your ordinary income. In a 30% bracket, this will save you $6,000 in taxes.
This is like found money because you did not have to spend any additional cash to get the deduction. The $6,000 as a 10% down payment can allow you to buy an additional $60,000 worth of real estate, which, at a 20% yearly return, would be $12,000 more income every year. Plus, like money in the bank, you get the deduction and tax savings every year (for the recovery period of the property).
Yet, when you sell, you can have no recapture and thus not have to pay any of these tax savings back by selling the property, tax-free, via the powerful 1031 exchange (covered later). You still continue to pocket the tax savings from depreciation. Money makes money; but saving taxes (every year) makes a whole lot more money so you can get wealthier, quicker!
So how can you make this already valuable deduction save you even more? Componentized!
Componentizing (or Cost Segregation Analysis) is something that I have been using for over 25 years to dramatically increase my cash flow (and wealth) via tax savings from much larger depreciation deductions. Many of my students also use it with the same money-saving results.
Reason: With componentizing, you break out components, from the property cost, that allow you to use shorter recovery periods with the result of much larger deductions and savings. An overview of these components and strategies follow:
5-Year personal property — Included in the cost of your property are many items of “hidden” personal property that can be written off over 5 years, using a faster-accelerated method, instead of 27-1/2 or 39 years, using a slower straight-line method. Typically, the amount of personal property will be at least 10 to 20% of the cost of a rental property. Some Examples: Kitchen cabinets, shelves, storage, carpeting, appliances, movable wall partitions, including “non-weight” bearing interior walls. One of my students, Ron, installed $80,000 of non-weight bearing movable walls in his commercial property. Result: Because the walls can be moved without adversely affecting the building structure, they are considered personal property and can be depreciated over 5 years (accelerated) instead of 39 years (slower) straight-line. This equates to a $16,000 a year deduction vs. $2,000. Tax savings of over $5,000 for five years! (Plus Ron expanded his rental market with the movable walls giving his tenants more options as to office space). There are many other items of such personal property fully supported by tax law citations.
15-year land improvements to the land — Also included in the cost of your property are many items of land improvements that can be written off over 15 years, using a faster-accelerated method, instead of not being depreciated at all if they were part of the land. Some examples are landscaping, paved surfaces, and parking lots.
Land improvements to the building — These are depreciated along with the building (27-1/2 or 39years), instead of not being depreciated at all if they were part of the land. Some examples are outside lighting and utility connections to the building.
A low land value maximizes depreciation deductions — The land portion of the cost of the property is not eligible for depreciation deductions. The less of the property cost allocated toward non-depreciation land, the more toward the other depreciable components, the more non-cash deductions, the more savings. Don’t be talked into using a high land value! You can justify a very low (or no) non-depreciable land value if you know the rules. Keep the following in mind – Allocations toward depreciable land improvements reduce the amount allocated to non-depreciable land. Special valuation factors have also worked to the taxpayer’s advantage in lowering the value of land (such as housing shortages).
Fully deduct the remaining basis of components that are replaced (gut out). For example, in doing a rehab, if you replace existing property components with a remaining componentized cost basis of $30,000, you can claim the entire $30,000 as a full ordinary deduction. In a 30% bracket, this puts $9,000 of savings in your pocket, yet you did not have to expend cash for the deduction!
So how much extra did you pay in taxes not using componentizing because your tax advisor did not know about this incredible legal strategy? According to the following quote from one of my students, probably a lot!
“Al, your component depreciation method saved me almost $20,000 dollars in income taxes. It helped me financially having four girls in College at the same time.” …Angelo D. Guerra, Investor, Broker/Owner, ERA Platinum Realtors, Conshohocken, PA.
By the way, that’s $20,000 a year, which if invested at 10% a year for the next 10 years would accumulate to over $318,000! That’s how much you lose!!
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