Real Estate Is Taxing

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.