Tax Planning Issues

Updated: Aug 17

How do you calculate depreciation for real estate? What are the qualifications required for a property improvement to qualify for one-year deduction?

Assume the following: Price of house $1,000,000 value of land $200,000

Value of improvements $800,000

Assume rental property, with a 27.5 year life

Annual depreciation is $800,000/27.5 = $29,090.90

Land is not depreciated

Improvements are depreciated

For real property that is the residence of the owner, with no business use (no Airbnb rental, no office at home) there is NO depreciation.

Depreciation is allowed for office at home (exclusive use), for proportion of area used Depreciation is allowed for person whose business is child care (non-exclusive use), for proportion of area used

Depreciation for real estate depends on use: Non- residential real property-39 year life (Office at home or short-term rental property)

Residential real property (single family or multi-family) 27.5 year life Depreciation starts mid-month for real property

The Section 179 life of one year is authorized for personal property, equipment, vehicles, fixtures, and INTERIOR improvements to qualified real property. Under 26 USC 179, one year depreciation for improvements to non-residental real property is authorized. By definition, non-residential real property is: Commercial property Industrial property Property used for short-term rental of residential real property (Airbnb use, hotels, motels)

By definition, improvements are not mere repair, maintenance or cleaning. Improvements are the result of expenditures which result in tangible changes and refinements which improve the useful life, appearance or quality and which are ordinarily are expected to provide benefits for several years.

By contrast, expenses such as maintenance, repair, or cleaning have short-term benefits and are one-year write- offs. Long-term benefits result in classification as capital expenditures, which are ordinarily depreciated over a period of years. But, under Section 179, even capital expenditures can be expensed in a single year.

Generally, outside of election of Section 179 one-year deprecation, the criteria for capitalization (depreciation) or expense (write off in one year) depends on the period of time expected for benefits from the investment. According, it is typical for research expenditures to have a 5 or 10 year life. However, if any expenditure is later determined to have to no continuing future benefit, the taxpayer can elect to depreciate all future years in a single year, based on extraordinary obsolescence.

Based on the accounting practice for a specific taxpayer, for each specific year, and with consideration for inflation, a limit of $5,000 or $7,500, or another limit is selected by the taxpayer, as the criteria for classification as a capital expenditure vs. an expense. For example, pencils and paper are expensed, but a computer may be capitalized or expensed, depending on the accounting practice of the taxpayer.

For many investors, real property can be an excellent investment. The key is careful selection of the location. For a farm or ranch, the improvements, equipment and expenses appropriate for the business operation are deductible. Ordinarily, the land, such as 100 acres, might be rented to an individual or firm that would grow crops or use land and barns for animal care. Later, the farm land can be converted to use for 10 acre luxury residences. Over a 20 year period, farm land in selected locations can result in substantial increases in value, based on land development efforts to convert from farm use to high-quality residential use.

How do you calculate depreciation for a car? Depreciation for a car depends on the price paid for the car. If the price is under $50,000, 26 USC §179 one-year depreciation is authorized. Under new statutes, both used and new vehicles qualify for one-year depreciation, if the purchase price is less than $50,000.

For costs over $50,000, or if the taxpayer does not choose one-year write off, a car has a 5 year life, and accelerated depreciation (Modified Accelerated Cost Recovery System-MACRS) can be used. Details regarding depreciation are shown at 26 USC §168.

What is the tax result when you sell a house? How do you calculate the capital gain that is taxed? What is the general strategy as to how to minimize taxes?

The first general strategy to minimize tax is to purchase a residence, keep the house for several years to benefit from increase in value due to (1) inflation and (2) increased demand due to your investments in a new kitchen, new bathrooms, new windows, and new doors.

Basis(the original cost)

Land $100,000 Improvements 500,000

Total cost $600,000

Adjusted basis

Improvements $200,000 Depreciation deducted 100,000

Total, Adjusted basis $700,000

Amount Received on sale $1,000,000

Capital Gain $300,000 There is NO tax on this capital gain of up to $500,000 if the husband and wife lived in the house for 2 of the past 5 years, 26 USC §121. For a single taxpayer, there is NO tax on $250,000. Separately, there is no capital gains tax on the first $78,760 for 2019, and a slightly higher exclusion for later years. This income tax is

forever lost to the tax system.

The next general strategy is stepped-up basis. When property is held as joint tenants, the instant before death, the ownership of property is immediately vested in the surviving joint tenants, so that the estate of the deceased does not include the value of the house previously owned by the decedent.

The basis of inherited property is stepped-up to market value of the property at the date of death, 26 USC §1014. This way, there is no taxable gain in the property is sold promptly after the date of death. If the property is sold several years later, the gain and tax would be measured from the stepped up basis, not from the original cost.

Basis of property

Cost $250,000 Improvements $100,000

Total cost $350,000

Value at death $2,350,000 Stepped-up basis $2,350,000

Economic gain $2,000,000

Taxable gain zero

Again, this income tax is forever lost to the tax system.

What is a good strategy when you buy a house?

When you buy a house, make sure the location and quality allow the house to be sold for more than you paid for it several years into the future. If you made a bad choice, just wait 10 years, and inflation will result in substantial increase in price, provided the location is good.

Generally, the objective when you purchase a house is to select a location that would supportafavorablequalityoflife. Forsomeinvestors,itisgoodtobewithinshortdrivingdistance of good private

pre-college schools, shopping, a major hospital, and cultural centers, such as opera, symphony, or live theater. Accordingly, proximity to a beach, a river, or a lake is good. Also, it is good to select property that is close to a major university. For favorable price with the opportunity for rapid appreciation, it is good to select property on the edge of a very expensive neighborhood.

To take full advantage of tax benefits, it is good for your property to have a separate guest house, which can be an attached structure with a separate entrance and a private fenced back yards. Then, with rental income from Airbnb, you benefit from high rental income and the opportunity for one-year depreciation for interior improvements to your rental property. For purchase of a second home, different criteria may include separation from civilization, such as a large range or farm adjacent to a national park. Over a period of years, the property can provide rental income, and for use as a short-term rental, one-year depreciation of interior improvements is authorized.

What is a good strategy when you buy a car?

When you buy a car, consider: Durability—look for at least 150,000 to 400,000 miles useful life Cost- choose a vehicle priced under $50,000 to be under the Luxury vehicle limit

Performance- acceleration and handling must be sufficient to keep you out of trouble

Value decline over time—select brands that retain a higher resale value over time

For many investors, it is prudent to purchase a used Tesla model S. As you might expect, the price of a used Tesla is significantly less than a new Tesla. Current experience indicates that the useful life of a Tesla is 800,000 to 900,000 miles, due to few moving parts. The operating cost is low, with no tune-ups, no transmission and no differential to wear out, and costs primarily for tires, brakes, wiper blades, and routine maintenance every 24,000 miles.

Note that Tesla Superchargers, now located within under 50 miles apart nationwide, allow long distance travel with 45-minute stops every 100 to 200 miles to recharge the batteries. Although several other manufacturers now make electric cars, Tesla is widely recognized as superior in acceleration, handling, and overall quality.

For a multi-generational family, your vehicle may require a capacity for four adults and two children, plus luggage and room for a large dog. For some investors, it is good to specialize in only collector cars, such as a 300SL gull-wing Mercedes or selected Ferrari or Lamborghini models. This approach requires access to a talented mechanic who is experienced in rebuilding old vehicles to ten-point perfection required for auto shows. For insiders, it is possible to make substantial profit with carefully selected vehicles.

As an investment, it is good to purchase personal property, such as a car, and lease it to another person. For full tax benefits, it is necessary for the lessee and lessor to not be related persons. Inlaws are not counted as related persons. For lease arrangements of personal property of real property, it is possible to design the transaction to benefit from one-year depreciation, and to schedule the income recognized to provide the best balance of income and expense for each tax year.

2020 Copyright. Richard Sylvester PhD
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