Tools of the Rich #1 – Depreciation
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An October 13th, 2018 article in the New York Times discussed how Jared Kushner avoided paying almost no federal income taxes several years running. According to the article, Kushner, who has a net worth of $324M plus, paid little to no taxes from 2009 through 2016. Just by my first two sentences, you can see the slant of the article – how things are tilted unfairly toward the rich.
To avoid paying taxes, the article pointed out that Kushner used “depreciation, a tax benefit that lets real estate investors deduct a portion of the cost of their buildings from their taxable income every year.”
Before we get too far into this post, let me state one thing – I didn’t vote for the current president nor do I like how he’s running the White House. That will be the most political I say on this blog as I’ve tried to be very apolitical. However, I’m going to defend Mr. Kushner’s use of depreciation throughout this post and I don’t want anyone to believe I’m doing so for political reasons. I’m doing it strictly because it’s the right thing to do.
As we get started, let me be clear. The depreciation “tool” is available for every real estate investor, but you must get in the game to use it. Otherwise, you’ll just be standing on the sidelines, wondering how come there are others running up and down the field.
The New York Times article pointed out that “nothing in the [financial] documents suggests Mr. Kushner or his company broke the law.”
However, the authors then followed up their opening paragraphs with a one-two punch of “in theory” versus “in practice” statements in which they took the position that depreciation is a “lucrative giveaway to developers like Mr. Trump and Mr. Kushner.” Uhm. Wow.
They followed up their lucrative giveaway scare by saying depreciation “allows real estate investors to determine their own tax bills.”
Oh my God, I wish I could determine my own tax bill. Seriously, I would call the IRS up today and say, “Zero. I’m paying zero.”
No, real estate investors don’t get to “determine their own tax bills.” They still must go through the process of meeting with an accounting firm annually to determine how much is owed to the government. It’s a long, pain, and expensive process.
The difference is that most real estate investors think about their tax liability throughout the year, looking for ways to improve their position with the taxman. How many non-investors even give five minutes of consideration to their taxes during the year? More than likely, they don’t. They don’t think about their taxes until January 1st rolls around and they hope they can e-file as quickly as possible and get a return.
This type of reporting frustrates me as I’m a real estate investor (albeit on the smaller end of the scale compared to Mr. Kushner). I use depreciation and it’s not a lucrative giveaway as the reports so falsely claimed.
I’m going to go way out on a limb and assume (you know what they say about assuming, but I’m going to do it anyway) that neither of the two reporters who were behind this story own any investment real estate.
If they did, they would realize just how silly (and petty) their article came off to those of us in the real estate field.
Let me explain.
Depreciation is NOT Spooky
First, let’s talk about paying taxes. None of us wants to pay taxes. I don’t want to pay taxes. Do you want to pay taxes? Not wanting to pay taxes does not make us un-American. If you even try to say it does, then you’re soft in the head. Pretending we all want to pay taxes is silly. Imagining that it’s some badge of honor to pay your “fair share” is naïve and foolish. We all want to pay less taxes. Let’s make more money and pay less taxes. That, my friends, is the American way.
Secondly, the authors clearly point out that Mr. Kushner did not break the law in the article, but they still tried to pass off depreciation as something dirty or underhanded.
Why would they do that? To sell newspapers for sure, but they failed to properly educate their readers about what depreciation was. Why do that when it was easier to point at Mr. Kushner and imply that he did something wrong, even after they clearly said he didn’t.
So what exactly is depreciation? According to Investopedia,
Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value
Investopedia has a good video on their site along with a detailed article on depreciation. However, here’s another one from Allden Investments that I liked a bit better.
So depreciation allows an investor to write-off a portion of an asset over its useful life. For residential property, that’s 27.5 years. For commercial property, that’s 39 years. Wow, really spooky and underhanded, right? Anyone who has taken a basic accounting course is familiar with the concept. It’s not mystical and it’s not mumbo-jumbo. It’s called math.
But back to the time periods of 27.5 and 39 years. Man, that is a significant holding period. To fully depreciate an asset, I would have to hold a building for a very long time.
For example, let’s say we purchased an office building for $1,000,000. The building has been valued at 75% building and 25% land. Since we can’t depreciate land, we’ll only be able to depreciate the building. Therefore, we can depreciate $750,000 over 39 years.
This is called “straight-line depreciation” and each year we will able to depreciate (write-off) $19,230.
I understand this is an extreme example – not many people are going to purchase a $1,000,000 building. Therefore, let’s look at something more reachable.
Let’s imagine I bought a $220,000 duplex as a rental with $200k allocated to the building and $20k allocated to the land. I would then be able to depreciate $200,000 over 27.5 years or $7,272/annually.
Any real estate investor, regardless of their size can take advantage of this depreciation “write-off,” right? Most folks who invest in real estate immediately understand that they’ll be able to depreciate their asset. It’s one of the main benefits of investing.
However, straight-line depreciation is the most basic level. There’s a whole other level of understanding surrounding depreciation. This usually occurs for those who are investing regularly in buildings that are over $500,000 or greater.
A Cost Segregation Study
Those investors can take advantage of process called a Cost Segregation Study. A “Cost Seg” essentially identifies the various systems within a building and moves them to different depreciation schedules. For example, HVAC systems, parking lots, carpeting, and more will be broken out from the overall building and placed on different depreciation schedules.
This is significant because instead of 27.5 years or 39 years, these smaller systems can be depreciated on 5, 10, or 15 year schedules. Some categories can even be expensed (written off) in the first year.
So a cost segregation study will take an asset’s depreciation schedule and make it look like a roller coaster that’s about ready to drop. A lot will be written off in the first few years and then it will decline considerably as time goes on.
“Wait!” someone will cry. “If you do the cost segregation study, you will lose almost all the depreciation at the latter end of the timeline.”
My response is, “Great! That’s what we want.”
First, money today is more valuable than money tomorrow (that’s the concept of Time Value of Money).
Second, I’m unlikely to hold any property for 27.5 years, let alone 39 years. More than likely we’re going to sell much sooner than that. Therefore, I want as much savings today as possible. When we sell, we’ll use another Tool of the Rich (a 1031 Exchange) that I’ll discuss next week.
Last tax year (2017), my investing partner and I did our first cost segregation studies. It was an eye-opening revelation how much the rapid depreciation savings had dramatically affected my income.
This tax year (2018), our understanding of the process went to a whole new level. We completed one transaction where the resulting savings from deprecation (a paper loss, mind you) will essentially wipe-out ¼ of my entire earnings this year. For the first time in my life, I’m excited to see how the tax process comes out.
When was the last time you said that about your taxes?
So back to the New York Times article about Mr. Kushner. The authors stated he played by the rules and didn’t have to pay taxes. Therefore, I’m envious. I haven’t reached that milestone yet, but I’m working toward it and hope to be there one day.
Do you think that’s fair?
If not, let me leave a final thought for you.
How do apartment renters feel about homeowners who get to deduct their mortgage interest from their taxes? Do they think it’s fair? Why should a large percentage of Americans be allowed to deduct their mortgage interest when others cannot? That’s clearly unfair towards those living in apartments.
What about the deduction for children? Is that fair to those who chose not to follow that course or cannot have children? Why should they be penalized with less deductions?
Fair is a naïve notion that will never be achieved. Trying to ensure everything is fair is a fool’s errand. Instead, we should look at the way the tax code is written. The government is trying to tell us what it wants us to do.
They want us to have children. (They give deductions to those who do)
They want us to buy houses and live in them. (The give the home interest deduction to those who do)
They want us to invest in investment real estate. (They give a slew of tax benefits to those who do)
We can either use the tax code to our benefit or we can choose to ignore it.
However, complaining about it isn’t action. It’s simply standing on the sideline as others run the ball up and down the field.
