Real Estate Asset Setup On Your Tax Returns

By Jason Watson, CPA
Posted Saturday, August 3, 2024

When you setup your asset on the fixed asset listing of your tax return, you will likely have at least two but usually three asset buckets-

• Land
• Building, including Acquisition Costs
• Loan Costs
• Certain Start-Up Costs (possibly)
• Improvements (to get things launched)

You might have another bucket for furnishings (so you can accelerate depreciation, but there is a danger), and you might even see the need to bifurcate building and acquisition costs as separate assets to tie out the numbers.

The word “fixed” might throw you off. Fixed assets are long-term assets. This means the assets have a useful life of more than one year. Fixed assets include property, plant, and equipment (PP&E) and are recorded as such on your tax returns (and financial statements should you have a balance sheet).

We’ll talk about these in turn except start-up costs which are discussed in a later section.

Intro to Depreciation

Before we get too far down the asset setup, let’s briefly discuss depreciation. Generally, real estate investors like depreciation since it is a cashless tax deduction. Other tax deductions such as advertising, management fees, utilities, HOA dues, repairs and maintenance, among many other things, require cash. Sure, they are a tax deduction, but cash is leaving you. To save $2,400 you must spend $10,000 assuming a 24% marginal tax bracket.

Depreciation is a cashless deduction. The principal portion of your mortgage payment requires cash and is not a tax deduction. These two don’t perfectly offset each other of course, but it does help.

Depending on the structure of the rental property purchase (cash versus loan versus investor), you could easily have a positive cash flow and a tax loss. Said differently- you could earn cash without paying taxes (at least not today since some taxes might be deferred and recaptured upon sale). The primary contribution to the positive cash tax loss situation is depreciation.

Sidebar: Upon sale of your rental property, depreciation is recaptured which means you might pay taxes back to the IRS on your prior depreciation deductions. In other words, depreciation is a little IOU to the IRS. Sure, a 1031 like-kind exchange can defer this recapture problem. At times you want to worry about next time, next time (kick the can sort of thing).

We like to have it, play with it, accelerate it, give it nicknames, maximize it, etc. This is why depreciation is such a popular topic. In some real estate investor homes, we bet depreciation has a place setting at dinnertime.

Land

Land cannot be depreciated, and as such it must be split out from the other assets. The question becomes- what portion of my purchase price is the land value? Good question!

The easiest way to determine this is using the county assessor’s ratio. Let’s say you purchase a rental property for $500,000, and according to the assessor’s data the parcel is assessed at $45,000 land and $180,000 building for a total of $225,000. In this example, land is 20% and using this ratio, you could assume that land is $100,000 on your $500,000 purchase leaving $400,000 as building.

Property tax assessments are not always accurate. Poke around the records of other properties nearby and see if things make sense. Assessments might not include a new addition or a finished basement, or other things that increase the building portion of the overall value. If you are obtaining an appraisal, asking for the breakdown might prove worthwhile.

Condominiums become a conundrum since the homeowner’s association might own the land or it is on some weird land lease with the county or state. In some cases, the land is held as tenants in common with all the owners. Here is something to think about-

According to Colorado Homeowners Association Law, a law firm in Colorado, and their “Whose Land is it Anyway? And Why do we Care?“ article-

The Colorado Common Interest Ownership Act (CCIOA) defines two different types of common interest communities – condominiums, and planned communities. Planned communities are anything that is not a condominium. A condominium is a common interest community in which portions of the property are designated for separate ownership (the condominium units themselves), and the remaining property is designated for common ownership solely by the owners. In other words, the owners own the common property, typically as tenants in common with each other, and the association doesn’t have title to any of the common area property. On the other hand, in a planned community, title to the common areas is typically conveyed to, and held by, the association.

Gee whiz, right? Certainly, the purchase price of a condominium contains some land value- the same condo building in Malibu as in Toledo, Ohio will have vastly different values based on location alone. Is location the same as land? Perhaps.

However, most tax professionals would agree that assigning $0 or some super nominal amount such as $100 to land favors the taxpayer in the form of depreciation. In other words, more of the rental property is allocated to building, which is depreciable, than land, which is not. A quick review of the assessor’s data might provide some insights even with condominiums.

Rules of thumb are hard to come by. Two homes with identical statistics such as size, bedrooms and age can have wildly different ratios between building and land simply based on location which includes the relative demographic income. As such, a ratio in a small Texas town might not work the same as a high-density segment of Denver, Colorado.

Building and Acquisition Costs

We discussed acquisition costs in a previous section. Some tax professionals will tease out the acquisition costs and list two assets- the building itself less land allocation, and acquisition costs. The intent in part is to signal that acquisition costs have been accounted for properly on the fixed asset listing.

Loan Costs

See previous section on Rental Property Acquisition Costs. Been there. Done that.

Furnishings

This is a can of worms. If you purchase a rental property that is furnished (for example, a turnkey short-term rental), you might be inclined to separate a chunk of the purchase price, allocate it to furnishings, and then list the grouping as a separate asset on your fixed asset listing. The primary motivation would be to accelerate the depreciation of the furnishings. This might be bad for two reasons-

• For example, you have $25,000 listed as furnishings. You replace the couch. Now you must go through the rigmarole of a partial asset disposition where you unbundle the asset and dispose of the couch. You might trigger depreciation recapture based on the fair market value of the old couch (let’s say you sold it for $250). The new couch is likely under $2,500 and therefore would be immediately expensed wiping out the depreciation recapture, but what a big ol’ hassle, no? We will review the $2,500 de minimis safe harbor and other safe harbors in a later section.
• Many local cities and counties impose a tangible personal property tax on each piece of equipment (Yes, furnishings count as equipment) that is used to produce income. By not tracking furnishings directly on your fixed asset listing of your tax return, you might mitigate this tax.

Another issue becomes separating the rental property acquisition into two deals- real property and personal property. This in itself is not challenging, but many real estate investors want to finance as much as they can, and a separate deal might require separate cash.

Not all is lost- you might be able to have a detailed listing of the furnishings complete with fair market values that can be used to leverage the de minimis safe harbor election (more on this in a bit) and be immediately expensed. No fixed asset listing. All the deduction. No calories. All the taste.

Multiple Units

When you purchase a duplex, a triplex or a 4-unit, or even a home with an auxiliary dwelling unit (ADU) or converted garage / attic, it is ideal to split these into multiple assets on your fixed asset listing. There are three primary reasons-

• You might want to take one unit out of service (off-line) to renovate. You might also move into a unit directly. By having separated units listed as assets, you can put various units into service and take them out of service very easily without a bunch of math gymnastics. Many tax professionals and DIYers do not spend the extra few minutes to set this up but they should.
• Let’s say you have a rental property that also has an ADU. One day you wake up and want to make the ADU a short-term rental. By already having the assets split on your prior year tax returns with assigned unadjusted cost basis from the original purchase, you can create another activity, and then easily move the asset plus its associated historical data (generally you need two activities since one will be a long-term rental and the other will be short-term).
• Along similar lines, there might be better cost segregation results on each unit. When a cost segregation study is done, additional assets are added to your fixed asset listing and are connected with building. As such, keeping things separated is neat and tidy.

While the second reason is a bit more obscure, setting up your asset listings to be flexible for what the future might bring is good housekeeping (but not necessarily required… like flossing). Here is an example of a lovely rental in Amityville-

108 Ocean Avenue – Building + Acq Costs
108 Ocean Avenue – Converted Garage
108 Ocean Avenue – Loan Costs
108 Ocean Avenue – Land

A lot of house hackers, where you live in a unit or a portion of the house while renting out the remainder, will set up their assets in this fashion as well. Fun!

Basic Depreciation and Amortization Life

Here is a quick summary of the basic depreciation and amortization life schedules-

• Residential buildings- 27.5 years.
• Commercial buildings and short-term rentals- 39.0 years.
• Acquisition Costs- follow the primary building above but as amortization.
• Loan Costs- life of the loan, usually 30 or 15 years for residential, and 20 or 25 years for commercial.