The unpredictable calendar year of 2020 is slowly drawing to a close, and as we set our sights to greener pastures in 2021, we must finish up our tax planning for 2020. There are many important considerations that you, the real estate investor, will need to determine to execute your overall strategy. In the below, you will learn how non-paying tenants and advanced depreciation strategies will impact your taxes.
Rental Income Loss Due to Non-Paying Tenants
If your tenant(s) haven’t paid rent during the year, you’re not the only one. The good news, at least when it comes to taxes, is that you’ll have less rental income from your properties. As a result, you’ll either have a reduced gain or larger loss on your properties, meaning you’ll pay less in tax. Should you have a loss, please refer to my previous article for the potential deductibility. See the below example for further clarification.
You own one property during the year. Let’s assume that rents are $24,000 for the year, or $2,000 per month. Expenses, including depreciation, are $21,600 for the year, or $1,800 per month. Based on these numbers, you’d expect a $2,400 profit for taxes. However, due to economic hardships, your tenant missed three months of rent, or $6,000. This means instead of $24,000 in rent, you now have $18,000 in rent and $21,600 in expenses netting to a $3,600 loss.
As part of the 2017 tax legislation, our government introduced legislation that allowed businesses and real estate investors to take 100% bonus depreciation on qualified assets placed into service. Bonus depreciation gives investors the opportunity to deduct 100% of the costs associated with a qualified asset in the year of purchase. This provision lasts until the end of 2022 (barring any legislation changes). Breaking the tax jargon down, the phrase “placed into service” means the date that the asset is in use for its intended purpose. See the below example for additional clarification. The qualified assets are anything that has less than a 20 year useful life (i.e. anything but the building, HVAC systems, windows, etc). See the below example that more easily illustrates the concept and the IRS property classes on page 29 on their website.
Placed asset into service example:
An example of this would be that you upgrade your parking area by installing asphalt or concrete. The project starts on January 15th and it is finished on February 1st. The date it is placed into service is February 1st since that is the first time the parking area is ready for use.
Bonus Depreciation Example:
Using the same type of asset (parking area), this is a land improvement. Land improvements are typically eligible for 15 year depreciation. However, given that this asset is under 20 years of useful life (as determined by the IRS), you may take bonus depreciation on 100% of the assets cost. If the asset costs $8,000, you have the option of taking an $8,000 of deduction in the current year, or spreading that depreciation over 15 years ($533 depreciation per year).
If a real estate investor were to purchase a building, they would have the option of utilizing a cost segregation study. A cost segregation study is a common tool for those that have purchased real estate. It typically reduces taxes by identifying components that have a shorter depreciable life than the building itself. Common examples are appliances and land improvements. Depending on the size of the building and the investor’s need for depreciation deductions that year, it may be beneficial as the specific components that are less than 20 years may be eligible for 100% bonus depreciation. If bonus depreciation is not elected, there will still be accelerated depreciation on those assets as those are separately identified and depreciated over a shorter period.
Cost Segregation and Bonus Depreciation Example:
A real estate investor purchases a building for $700,000. The investor engages a cost segregation firm to conduct the study. The study finds that there is $15,000 worth of five-year property and $25,000 of fifteen year property. The real estate investor may be able to deduct $40,000 in the first year of owning the property. Depending upon the investor’s tax situation, they may want to deduct all of the depreciation associated with the five year and fifteen year assets or just accelerate the depreciation using the five year and fifteen year useful life periods (instead of the 27.5 years for residential real estate). It truly depends on the investor’s overall tax strategy.
One other item to note with regards to cost segregation is that when you accelerate or take bonus depreciation, you reduce the amount that you may take for your building’s depreciation (normally depreciated over 27.5 years). In other words, you don’t get to depreciate the specific assets that you break out for accelerated or bonus depreciation twice. In this example, the amount that must be broken between building and land is $660,000 ($700,000 - $15,000 - $25,000).
Wrapping It All Up
Most real estate investors know that depreciation is an extremely powerful tool for reducing tax liabilities. However, there are further opportunities to accelerate depreciation in the year of purchase or when additional improvements are made. Conversations need to be had to determine what is best for the overall tax strategy for the real estate investor especially given the context of potentially lower rental income for 2020 . These are some of the questions to consider when discussing with your tax advisor:
Would it be best to take the bonus depreciation in the current year or defer the depreciation benefit into later years?
Is it worth it to get a cost segregation study for the building(s) purchased in the current year?
If you have questions on your real estate tax strategy, you can reach me (Aaron Zimmerman) at firstname.lastname@example.org.