Investment real estate offers different things to different investors. Some buy real estate in hopes of appreciation, some investors buy real estate for the monthly cash flow, and others buy investment real estate for the tax benefits. There is a large part of the investment community that buys for all these reasons. So what kind of investor are you?

Congress, along with the Internal Revenue Service, offers a host of financial benefits to those who invest in real estate. From subsidized housing programs like Section 8 to the Gulf Opportunity Zone (GO Zone), real estate is as attractive an investment as ever, thanks in large part to the federal government. The tax benefits of investing in real estate can often greatly increase ROI.

Take a rental property, for example. The IRS allows a multitude of tax deductions, including: mortgage interest, travel, tenant background checks, repairs, utilities, advertising, landscaping, pest control, professional fees, and the list goes on. These are all expenses classified by the IRS. Anytime you have one of these expenses, you’ll most likely write a check or use your credit card to pay for it. So if you collect $1500 in rent and then pay all of these expenses, you may have $250 left in your account at the end of that month. That’s not so bad when you invest in real estate to generate cash flow.

However, there is another “expense” that the IRS allows you to take. It’s called depreciation. Although depreciation is classified as an expense, a check is not written to pay for it. Depreciation allows you to spread the cost of the building over a period of time and take a portion of that purchase price over that time. Commercial buildings typically have a depreciation period of 39 years, while residential buildings have a depreciation period of 27.5 years. Depreciation is considered only on the building, the cost of the land must be eliminated before calculating annual depreciation. Let’s look at an example:

Purchase price of the home: $200,000.

Land Value: $40,000.

Building amount to be depreciated: $160,000.

As you can see, we have a purchase price of the house of $200,000 and the land was valued at $40,000. Subtracting the land value of $40,000 from the total purchase price of $200,000, we are left with a building value of $160,000. Under current IRS rules, this $160,000 can now be spread over 27.5 years. So take $160,000/27.5 = $5,818.18 per year.

However, the building is not the only part of your rental property that can depreciate. The IRS Tax Code also allows you to depreciate “personal property,” called Chattel. Also, the IRS allows you to accelerate this depreciation over a shorter period of 5 to 15 years. Let’s look at a bit of history on how this IRS tax deduction came to be. A short case called Hospital Corporation of America v. communication [109 TC 21 (1977)] makes all this possible. This case rules that it is permissible to separate Section 1245 property from Section 1250 property. Your CPA should be familiar with section 1245 property and section 1250 property. After this case was resolved, the IRS issued a Guide to Auditing Techniques ([http://www.irs.gov/businesses/small/article/0],,id=108149,00.html) on cost segregation. In this guide, the IRS outlines several methods for determining Section 1245 property value. One of the methods is the “Residual Estimation Approach.”

Basically, what this allows the owner of a rental property to do is to segregate the value of the chattel or personal property and accelerate the depreciation of its value over a period of 5 or 15 years.

So what is movable property? The IRS has identified more than 65 items that qualify as personal property, including: flooring, cabinets, countertops, lighting, blinds, appliances, landscaping, walkways, driveways, swimming pools, etc. So how much personal property is there in a rental property? A conservative amount to use is 10% of the purchase price. Many times, this percentage is much higher. Let’s go back to our original example above and use a personal property amount of 10%:

Purchase price of the home: $200,000.

Land Value: $40,000.

Movable value: $20,000.

Building amount to be depreciated: $140,000.

Now let’s calculate our new depreciation amount, including the value of personal property:

Building depreciation: $140,000/27.5 = $5,090.91.

Personal Property Depreciation: $20,000/5 (allowable years) = $4,000.

Total Depreciation: $5,090.91+ $4,000 = $9,090.91.

Additional Depreciation: $9,090.91 – $5,818.18 = $3,272.73.

By segregating the value of the personal property from the value of the building, we obtain an additional tax deduction of $3,272.73. Let’s look at the actual dollar savings:

Depreciation Amount: $5,818.18 x 25% Tax Bracket = $1454.55.

Depreciation amount with Personal Property: $9,090.91 x 25% Tax Bracket = $2272.73.

Tax Savings: $2272.73 – $1454.55 = $818.18.

Please note that these are conservative numbers. So now you may be thinking, what are the drawbacks? You should always consult with your tax advisor before employing a new tax strategy. The most common question about personal property is the concept of repossession and the repossession tax when you sell the property. You may already know that you pay for the recovery with straight-line depreciation over 27.5 years. The catch-up also applies to accelerated depreciation taken through this tax strategy.

Let’s briefly talk about repossession and the repossession tax. A recovery tax is applied each time a depreciated asset is sold. The amount recaptured is subject to a maximum rate of 25%. The recovery tax percentage rate is based on the investors’ income tax rate and is capped at 25%. This allows you to keep 75% and use the time value of money to create more investments. Let’s use our previous example to illustrate recovery. We will assume that the investment property was held for five years before it was sold:

Purchase price of the home: $200,000.

Depreciation taken: $9,090.91 x 5 (years) = $45,454.55.

Selling price of the house: $250,000.

Recovery Tax: $45,454.55 x 25% (maximum rate) = $11,363.64.

How many additional properties could you buy with $11,363.64 available before having to pay it back? Is it one, three or more? Remember, if your tax rate is higher than 25%, you will keep the difference since you are capped at 25%. This strategy also works with multi-family properties. Savings with multiple units are multiplied enormously. If you own or are buying a large multi-family property, ask your tax professional about the Section 179 deduction. It provides over $100,000 in deductions with specific criteria.

Now the $50,000, which is the difference between our selling price of $250,000 and our original purchase price of $200,000, is subject to capital gains. That is, unless you have used another strategy, such as the 1031 Exchange or a Charitable Remaining Trust. The amount of depreciation is not subject to capital gain. Again, always consult with your tax advisor before making a tax strategy decision.

Congress and the IRS have made real estate such an attractive investment opportunity that it pays to use every available strategy to maximize your cash flow and lower your taxes. Ask your tax advisor about a personal property appraisal and cost segregation study and start using the tax code to your advantage!