Speaker: Welcome to Real Estate is Taxing, where we talk about all things real estate
tax and break down complex concepts into understandable, entertaining tax topics.
My name is Natalie Kalady, I'm your host, and I am so excited
that you've decided to join me.
Hello.
Hello everyone.
Welcome to today's episode.
I wanted to take a quick moment to mention that there is so much
incredible tax education coming up.
If you are a tax professional who is listening.
And you are hoping to get in some CE this summer to attend some great webinars.
I would like to invite you to visit my website, which is natalie.tax
and check out everything coming up.
I'm speaking at multiple conferences.
I'm going to be all across the country.
Doing a handful of online webinars, it is going to be fantastic.
if you are an investor listening, come check me out at BP con this year.
I will be on the tax panel as well as doing a tax workshop on the first
day with the amazing Amanda Hunt.
So today, guys, I want to chat with you about.
Something that I think isn't so much misunderstood, but people just
choose to willfully do it wrong.
And I don't understand why I am just such a purist when it comes to following
rules that I think are reasonable.
That's why I'm an accountant.
That I don't understand why someone would choose to do something wrong when
there's not really benefit or where there's like a cut and dry answer to it.
Right.
So.
Today, what I want to talk to you about is when you set up a rental property.
You get to choose your depreciable value.
And this is because it is not equal to your purchase price.
When you buy a rental.
You are only allowed to depreciate the building and improvements portion.
Land.
Doesn't wear out in theory.
So when you purchase something as one lump sum, which is typically what happens when
you buy a piece of real estate, right.
You're paying one price for everything.
You have to use a reasonable method for splitting the two up.
And there's a handful of ways you can do this.
I have seen some really off the walls way that people have chosen
to try to justify for doing this.
But in the end there's a handful of reasonable methods.
So a quick recap.
Depreciation is basically the tax codes way of saying if you
are using an asset over time to generate income in your business.
It should go down in value.
It should be wearing out.
And so because of this, they've created in the code.
A handful of depreciable lives and methods, so that
there's a standardized way.
To depreciate items.
for real estate, this is 27 and a half years for residential.
Or 39 years for anything that is non-residential.
what this means when you purchase a piece of real estate that
you put in services or rental.
The value of what you paid for.
We need to separate out land value and then the remaining amount for
your building and improvements.
We get to write that off, across that 27 and a half or 39 years.
When you purchase a property, there's likely also going to be some other costs.
Many of these get added to that starting amount.
We call it your basis.
These get added to your starting basis as well.
So any of the other costs.
It took to acquire the property that are connected to the
actual asset specifically.
I often get added into basis.
So some of these will be on your closing document, some won't.
So if you have a Hutter Alda statement, On there, you will likely
have some fees related to insurance or transfer fees, things like that.
Anything that is specifically related to the cost of buying the property.
If there's an inspection that makes it onto there.
All of these are going to get added to your basis.
Things that don't get added to basis are going to be things
like escrow account amounts.
So if you have to prepay.
Your homeowner's insurance or prepay some kind of a buffer into escrow.
Those don't get added to basis or expensed.
They're held in an escrow account.
This is just a separate account by the loan company that is
holding some of your funds.
So you don't get too expensive or.
Amortize it it's just there.
And then you expense it as costs are paid out of that account.
If there are expenses on your closing statement, which are typically these fall
under the category of items that could be income or expense, if there wasn't a sale.
Prepaid real estate taxes Transferred rents for a new owner or property taxes.
Most of those things fall into the expense category.
Anything that is a prepaid to escrow, goes into its own separate bucket.
It is neither an expense nor something we add to basis.
And then the other thing to exclude is going to be your loan costs.
So any of the costs that are directly connected to the
loan to acquire the property.
Those are amortized separately over the life of the loan.
when you buy a property, you have costs related to the property, and then you
have costs that the lender specifically requested or needed to get you the loan.
They're normally broken out into a whole separate category
on your closing statement.
These loan costs are not tied to the property necessarily.
They're tied to that loan, which might change over time.
So you're going to want to add those costs up on their own.
And you will have a separate line item.
On your depreciation schedule that will say loan costs, you know,
$4,800 or whatever it ends up being.
And those will be amortized across 30 years or 15 years,
whatever the life of your loan is.
This is important.
And I often see this overlooked.
Because a lot of us refinance loans.
If you have loan fees that you're still writing off, you know, you're
only in year 12 out of 15 and you refinance into a whole new loan.
The balance of those loan fees.
From your first loan, you get to write those off.
The loan is gone.
We don't get to keep expensing stuff for something we got rid of.
and then that new loan will have its own new set of fees.
And those will get added to that schedule as of that date across
however many years that new loan is.
So when you purchase.
You're going to have on your closing statement.
Loan fees.
That'll be in their own bucket, amortized over the life of the loan.
Escrow account items that are not an income or expense or depreciate it, these
are just going to be items you prepaid and there they're going to be expensed
as they're actually paid to the insurance company or to the county for taxes.
The escrow company is basically just holding them on your behalf.
And then you will have some closing costs.
And these are going to be what we add into basis.
once you have your closing costs, And any other costs that took
you to acquire the property?
These might be travel costs to go view the property.
These might be.
Additional inspections, or even if you had tried to buy another property in the
same city, And it fell through and maybe that whole endeavor costs you $8,000.
You know, you had to pay for some inspections, you put down
some nonrefundable earnest money.
And then after all of a sudden done, you decided it wasn't a good purchase.
The inspections came back, horrible building is just like filled with snakes.
So you walk away from it.
That $8,000.
That you put out, but didn't end up purchasing a property from
gets rolled into the next property that you do actually purchase.
It was a cost.
That was incurred to ultimately buy a rental.
Right.
It got you to that final destination there.
So you get to track all of those costs as well.
This is something I get asked pretty frequently because people will say, you
know, I spent $12,000 last year looking at rentals and I didn't end up buying
one, or I spent this much money, like going to a new city and investigating
to try to buy properties there.
How can I expense it?
You can't.
To the IRS.
Your business is the rental, right?
Those are one in the same.
If it doesn't exist yet, if you literally don't have an
asset to create a schedule II.
For a rental property.
Quote, rental property business.
There is nowhere to expense.
These costs.
You get to track them.
They're basically your startup costs.
So any costs that took you pre purchased that were directly
related to finding this property?
And these have to be direct.
Don't get obscure with it.
I don't want to hear you.
Trying to add in costs that you spent to like watch a webinar four years ago,
about how houses are built, like Nope.
Anything directly related, like you tried to buy a similar house,
it fell through, you tried to buy something else in that same area.
If you were trying to buy a house across the country, you were looking
at two different rental markets, completely different places.
We don't get to count those.
Typically it's based on where you are geographically.
So, if you are looking at properties in Florida and also Oregon, and
you spend some money looking at properties in Oregon, but you end
up only buying in Florida, we don't get to get those Oregon costs yet.
Not until you quote, open your business in Oregon.
Does it count there?
So.
Just a few nuances.
So once you got all of those costs, your prior costs, your closing
costs and your purchase costs.
These are going to create your starting basis in this property.
And then from there, we need to back out land value.
Because land, we don't get to depreciate.
It doesn't wear out.
So we need a way to figure out what the amount is for the land value.
So that we know what portion of the basis is appreciable and what isn't.
there are a few acceptable ways to do this.
And one that I would say is completely not acceptable.
There's actually two, I would say are completely not acceptable.
So starting with the worst,
I've heard this from tax professionals, quote, you can't see I'm air quoting.
Tax professionals.
That you should just not depreciate things like just don't appreciate the property.
Because when you sell something that's been depreciated, you have to pay it back.
So to avoid that recapture later, just don't write it off today.
That doesn't work.
Depreciation is allowed or allowable.
Which means whether you were sharp enough to take the benefit year to
year and actually get your write off.
When you go to sell it.
You are going to be taxed as though you did.
Anyway.
The calculation when you sell is based on the amount of depreciation
that should have been taken.
If you didn't take it.
That's on you.
You can fix it at that point, but just know.
That the idea of don't appreciate anything at all, because you'll
pay it back later and think you're like gaming the system here.
You are not, you are just setting yourself up to pay a tax on something
that you never got any benefit for.
So the first one is you have to depreciate depreciable property, not optional.
The second one is.
Don't.
Lump it all together.
Don't forget about land.
You always want to separate out bland value.
It's not optional either again.
That is not appreciable.
So you do have to separate that out.
It is not uncommon to see an appreciation report with nothing listed for land.
And what I will also say as a tip is whenever possible, if you are
either doing your own tax return or you are working with a professional.
First thing is you will always want to review this schedule.
A lot of professionals don't include it as a default with the tax return.
Ask for it.
You need to look at this and it should be included.
So you want to look at this schedule and you should see an amount for
building or improvements or the house address, whatever they're calling it.
And also ideally, a separate amount for land specifically.
The reason being without this.
If, what I see is just one amount there with nothing separated for land.
I don't know if five years ago your tax professional.
Actually separated land out of there, and then they just didn't list it
like, so the amount listed for the building is actually net of land.
But they didn't list land.
So I don't know.
Or if they didn't back land out and this is actually too high.
So having two separate line items for your depreciable amount of
building and improvements and separately for land is ideal.
And I know I throw out a lot of these little things that are
like, this is really helpful.
Or if you can try to see this ideally.
And it's because.
This is going to be a small side.
Tangent.
I promise I'll rein it in quickly.
At this point, 70% of tax professionals who were practicing in the last 10 years.
Are at about retirement age.
So we are having a huge disproportion and supply demand with available
tax professionals who are taking on clients and this and that.
And it's only going to get harder to find good tax professionals.
So every little thing counts.
And a lot of time with a tax professional.
Not always, I don't price this way, but many price based on time.
So if, when looking at your return, They now have to go back and look at
your purchase documents and ask more questions and like double check things.
Because looking at this.
It could be very wrong.
We don't know if land was netted out or not just because the prior professional
got lazy or just didn't think it mattered.
That adds time and time adds well, literally time, but also money.
If you are paying by the hour, you don't want to pay them for another
hour of their time looking into something that should have just been.
Clearly stated the first time.
So that's my little side tangent for today.
you want to make sure land is separated out.
And that there is a reasonable way for doing it right?
Because now what you're thinking is okay, Natalie, but I, I paid
$200,000 for this whole property.
How do I know what amount of that.
Is the land.
So, like I said, starting with the worst options.
The worst one being, not separating land.
The next option being.
Using a general rule of thumb.
I actually know of some pretty like large reputable tax firms doing it this way.
Based on, based on laziness, they'll call it efficiency, but doing something
wrong with the hopes of not getting caught is not efficiency to me.
Right.
Like, but you know, whatever, not my, not my circus.
So the general rule of the method would be saying that we always use on any property.
Like an 80, 20 split or 85 15, where we'll take 80% of the
value is building and 20 is land.
We just use that no matter what on anything.
And.
This is an appropriate, it's not something that is like an actual method of any sort.
Because property and land values can be significantly different.
Based on where you are.
I used to live in Seattle.
And when I lived there, I would have clients whose properties
would have a land value.
That was often the bulk of the value.
I've seen land values over 70%.
So in Seattle, you would have closer to an inverse of that standard where
it's closer to 70% of the value being land, which is non depreciable.
And then only 30 being the building.
Versus when I have clients who own properties in tiny towns in rural
America, it is like 90%, 95% building value and only 5% is the land.
So land value.
Is not, not equal for every property.
The next option.
The next three, I would say are reasonable.
You can use any of these three.
And.
The one that I typically will start with and I recommend you start with as
well, is the county assessors amounts.
Now.
I don't know about you guys, but my county seems to think properties are worth.
All kinds of values that are nowhere near current purchase prices.
Current fair market value.
They're often skewed.
For the overall value.
No argument there.
But the argument being that someone who works formally for the county, like
someone in this role has more knowledge.
And more of an appropriate skillset to separate out.
Land and building.
Then just you or I do.
Right.
So county assessor website, you're going to go to the county.
If you search for your county plus real property.
Your county plus real property lookup your county plus real property.
Value any of these keywords should hopefully land you there.
Your county plus assessor plus real property, like throw these all in there
to try to get you to the right page.
Depending on where you are.
Some of these are like Wix page built in 1998.
It seems so.
They're hard to find if you're in a smaller county.
Some of them aren't available online and you have to contact the county, but most
are, and most are pretty easy to find.
So you were going to go to the county website.
And you are going to look up your properties address.
From there.
It is going to give you a summary page that should have values for land.
Improvements.
Building sometimes they're separate because there might be
like a shed or an outbuilding.
And what you are going to do is you're going to want it for the current year.
We want the current year, whenever you're putting the property in service.
And you are going to use.
The ratio they use.
I do not use the literal amounts.
So if they say that the land is worth $20,000, And the
building is worth $80,000.
You are going to take 80% and multiply it by whatever your actual basis
is, whatever that total is of what.
You paid with closing costs and other costs to get the property.
That is what you are multiplying by 80%.
You were not just using the literal number.
They are saying it's worth, that's not reliable.
The percentage, the allocation between land versus building is what we're using.
So you want to take that same ratio and apply it to whatever your actual cost was.
This is the most common method.
And this is what I would recommend doing as your starting point.
And make sure you save a copy of that page.
Like print it to a PDF, save it in your file.
In case this is ever questioned, you can prove where you got that number from.
Because a lot of counties don't keep historic data on this up forever.
It's pretty limited.
The next thing to look at would be your appraisal.
When you purchased the property, there's a good chance you had an appraisal done.
If you used a lender.
Some appraisals go into land value.
Some do not.
So if your appraisal has a detailed site value appraisal with it,
or land value assessment, land value appraisal, as part of it.
Then you could use this amount.
Not all appraisals.
Do.
What I typically do as my starting point is I look at both of these.
And I see, which is better.
So they're often pretty close, but it's always worth it to look at the county,
figure out what the amount would be.
On the county, like using that ratio.
And then also look at your appraisal and see what your land value is there.
The goal is typically you want the lowest land value possible.
Because of the more building value you have.
The more depreciable value you have, which means the more your annual write-off is.
Your third option.
That is.
I would say a little less reliable, but still could be defended is having
a like limited scope appraisal done.
Or a site value done by an agent.
Who was basically pulling comps.
So, if you think that both of those first two values are way off.
If you have an agent who is skilled and who is appropriate
to pull comparable values for.
Raw land that has sold nearby in a recent timeframe.
That can be used as well.
if they can literally prove that, well, I can show 12 other lots that
are the same size that have sold within the last six months within a mile.
And they were all of this value.
You have an argument for the value of your lot as well.
So those are the three methods I would recommend using kind of in that order.
I always do one and two together.
Like I will always do look at the county assessor, look at the
formal appraisal from purchase.
And compare them.
If both of those are awful, or we just want more information, I will
suggest that the taxpayer have a list of land comms, polled as well.
those are kind of your options for choosing your land versus building value.
Going past that.
It has to be a reasonable amount.
I recently had a.
A few people reach out to me.
From a real estate group where I had spoke at one of their conferences
and they had they had a CPA.
On a podcast recently or something like that related to the group.
And so a couple of people worked with them.
And then a couple of people reached out to me after, cause they were like,
Natalie, this doesn't seem right.
And this CPA had just chosen.
I have no idea where he came out, but the amounts.
But on 25 different properties, I looked at, none of them had a
land value of more than $5,000.
And these were some properties were 600, $700,000 and it would be like $4,800 land.
I have no idea.
Where they came up with that amount.
And the other thing I will note as a red flag.
Or like a, I guess an orange flag, like slow down and take a look at this.
If you see it on your tax return.
If you get those taxes from your tax professional.
And on your depreciation schedule, if the amounts are exact dollar
amounts, That's pretty unlikely, right?
maybe your purchase price was an exact dollar amount.
Like you paid $200,000.
But then there's some fees and closing costs.
And once all of that is added in, and then we split it with a ratio.
The odds of that all landing on exact even dollar amounts.
And I round I'm not talking like pennies, like we're not talking that it should be.
You know, $12,500 and 82 cents.
But if the amounts are 12,500 and like 102,000.
That's normally pretty unlikely.
When it's like exact round large numbers like that.
So always question that.
To warnings with it.
One is I've had someone where.
They almost understood how to do this correctly.
And they used the literal land amount from the county website.
And the problem was that they then applied the ratio to figure
out their building amount.
So it's like they sorted, they almost got it, but they missed a part.
And so the end result was their total amount listed.
Was actually more than what they had paid for the property.
Because they separated out building value, but then the land for the county
was higher than what the land would have been based on what they paid.
And so, because they use the sort of whoops, mix and match.
When we went to sell it, I was like how does your tax return list
this property at $28,000 more than what you actually paid for it?
So be cautious with these.
I see a lot of mistakes related to this.
Like I said, that CPA, I have no idea where he was getting like $4,000 on
these large properties for land value.
I've got nothing.
I have no idea.
But we do have one court case on this.
It's the Nielsen case.
So, if you want to read the tax court summary of opinion, it's 2017 dash 31.
And in this case, this person bought properties in California.
and the taxpayer did not separate out land value.
So they were depreciating the full amount.
Of everything they paid, which included building and land
value, they did not separate it.
So.
When this was looked at under audit, they were like, well, your
depreciation seems too high for these properties and this and that.
So for example, on one property.
The taxpayer had paid $360,000 in 2003.
And there were three buildings on it at the time.
It was a multiunit property.
In 2012, when this was being looked at, the county had the property
valued at 4 25 and some change.
But of that.
Oh, that 425,000.
$236,000 was land.
So this was a situation where land value was the majority of the value.
Versus building.
So this is why it really matters where you are.
This was right outside of LA.
So land value was most of the value.
So it worked out to.
The building value, the improvements, the part that the taxpayer should get
to depreciate would have only been 44%.
Of the total amount.
This means they were taking like 60% more of an annual write-off
than they should've been.
So they fought about it.
They took it to tax court.
And the taxpayer's argument was that.
The county assessors are nowhere near accurate.
And like I said earlier, I would agree with that as a whole.
Right.
I think the total amount, they value things that is.
Nowhere near what people have paid for properties fairly often.
But this was their argument was that the county assessor was just inaccurate.
It doesn't excuse the part of them.
I'm not backing out land.
They didn't make a good faith attempt at it.
But at the end of the day, What the tax court landed on.
Was this idea that well, you, as a taxpayer.
Might be more qualified to speak to the actual value of your property.
Like, you know, what you paid for it, you know what.
What similar houses sold for, you were probably looking at
properties really similarly.
So they were like, no argument.
That you have a good idea of the value of your property.
Where their issue was.
Was that they felt that even if you know the value of your property,
You are in no way qualified to know.
The allocation amounts or how to properly allocate within that value, how much
is building versus how much is land.
And the court felt that the county assessor was a much more reliable option.
So ultimately the tax court has kind of stamped off on the county, assessor
allocation, being something they consider to be a reliable method to use.
So that's what I recommend starting with.
But there are a few different options.
So as always, I hope that this episode provided some value for you guys and
helped add a little clarity on how to set up your land versus building
value for a new rental property.
If you have any followup questions, I would love to invite
you to join me on Facebook.
I do have two different Facebook groups.
If you're a tax professional, please come check out the rental and real estate
taxation for tax professionals group.
If you are a real estate investor, please come join us in the real
estate tax strategies group.
I will have links for both in the show notes and as always, I would love it.
If you would like share and follow and feel free to submit.
Ideas for new episodes coming forward.
Thanks so much guys.
And I will talk to you next week.