3 Step Approach to Maximizing the Magic of Depreciation in Rental Real Estate

As I shared last week, real estate is one of the most complex areas when it comes to tax law and accounting which can easily lead to mistakes.

A common mistake I see with rental real estate is the amount of depreciation taken.

If you’ve ever heard me talk about depreciation, then you know I think depreciation is like magic. Rental real estate can be depreciated, and when done properly, it can take rental real estate with positive cash flow and turn it into a loss for tax purposes.

That is magical!

When I work with a new client who owns rental real estate, I don’t immediately jump to the depreciation step. Instead, I do a few other steps first to make sure the tax benefits of depreciation are maximized,

Here is my 3 Step Approach to Maximizing the Magic of Depreciation in Rental Real Estate

Step #1: How much tax did they pay? I want to know what the tax saving opportunities are and that starts with how much tax they are currently paying. If their tax liability is already low, then the immediate focus shifts from reducing taxes to building wealth.

Usually, I find they have a large tax liability, so I move to Step #2 because reducing their taxes is the fastest way to put cash in their pocket to build their wealth.

Step #2: Are they able to take all of their rental losses against their other income? In the U.S., the ability to take rental losses against other income depends on specific facts and circumstances. If my new client is not able to claim all of their rental losses against their other income, my immediate focus will be on fixing this. If I can fix this, it can result in big tax savings.

Once they are able to claim their rental losses against their other income, I then move on to Step #3 – this is where the magic of depreciation happens.

Step #3: Are they maximizing their depreciation? It’s pretty rare that I see a tax return from a new client with depreciation done in a way that accelerates the depreciation deduction (legally).

What I most commonly see on these tax returns is a rental property being treated as having two components: land and building. These happen to be the two worst classifications when it comes to depreciation.

Most rental properties have many more components than this. There may be appliances, parking structures, landscaping, furniture, fixtures, and much more. These items can be depreciated much faster than land and building.

This concept of identifying the different components is known as a cost segregation.

Even though the total depreciation over the lifetime of the property will be the same, by taking the depreciation sooner, the tax savings occur sooner which means more cash in your pocket now to build your wealth faster.

For those who have large tax liabilities (Step 1) and can take their rental losses against their other income (Step 2), a cost segregation can mean big tax savings – NOW.

My 3 Step Approach I find that sometimes taxpayers get caught up in the excitement of claiming the biggest deduction possible without first looking to determine if it will actually reduce their taxes.

A big deduction doesn’t always result in big tax savings.

This is why I do Step #1 and Step #2 first. These 2 steps identify the key factors to make sure the magic of depreciation in your rental real estate is maximized.

As I shared last week, real estate is one of the most complex areas when it comes to tax law and accounting which can easily lead to mistakes.

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