I am talking about the most powerful deduction for the real estate investor – Depreciation – which is an annual tax write-off of the cost basis of assets held for rental or business-use, such as real estate.
Why this "NO-cash-out; yet cash-IN" phenomena?
The first part, "NO cash out" is because the determination of depreciation is based on the entire cost of the property, regardless of how the property is financed. So you can do what is so frequently done, put little or no money down on a property and still take depreciation on the entire cost of the depreciable property. That is, you do not have to spend any cash for valuable depreciation deductions.
The second part, "cash IN" is because of the tax savings generated by depreciation, especially with componentizing (discussed later). That is you pocket the tax savings, while the property is appreciating. For example, a $20,000 depreciation deduction reduces your ordinary income.
In a 30% bracket this will save you $6,000 in taxes. This is like found money because you did not have to spend any additional cash to get the deduction. The $6,000 as a 10% down payment can allow you to buy an additional $60,000 worth of real estate, which, at a 20% yearly return, would be $12,000 more income every year. Plus, like money in the bank, you get the deduction and tax savings every year (for the recovery period of the property). Yet, when you sell, you can have no recapture and thus not have to pay any of these tax savings back by selling the property, tax free, via the powerful 1031 Exchange or other tax-free selling strategies. You still continue to pocket the tax savings from depreciation. You get the best of all worlds! Get the picture? Money makes money but saving taxes (every year) makes a whole lot more money, so you can get richer, faster.
So how can you make this already valuable deduction save you even more money? Componentize.
Componentizing (or Cost Segregation Analysis) is something that I have been using for over 25 years to dramatically increase my cash flow (and wealth) via tax savings from much larger depreciation deductions.
Reason: With componentizing, you break out components, from the property cost, that allow you to use shorter recovery periods with the result of much larger deductions and savings. For example there are many items that can qualify for personal property and be rapidly written off over 5 years (doubleaccelerated) instead of slower building depreciation of 27-1/2 or 39 years straight-line (or 6 times faster than the building). There are land components that too can be rapidly written off over 15 years (accelerated) instead of 27-1/2 or 39 years straight-line (or 2 to 3 times faster than the building).
Moreover, with my Goldmine system of componentizing, you can justify a low or no land value for even more deductions and savings.
Furthermore, you can also fully deduct the remaining basis of components that are replaced.
For example, if you replace existing property components with a remaining componentized cost basis of $30,000, you can claim the entire $30,000 as a full ordinary deduction. In a 30% bracket this puts $9,000 of savings in your pocket, yet you did not have to expend cash for the deduction.
So how much extra did you pay in taxes not using \ componentizing because your tax advisor did not know about this incredible legal strategy? According to the follow quote from one of my students, probably a lot.
"Al, your component depreciation method saved me almost $20,000 dollars in income taxes. It helped me financially having four girls in College at the same time." Angelo D. Guerra, Investor, Broker/Owner, ERA Platinum Realtors, Conshohocken, PA.
By the way, that’s $20,000 a year, which if invested at 10% a year for the next 10 years would accumulate to over $318,000. But with real estate the returns are even greater; so if at 20% for the next 10 years, the savings would accumulate to over half-million dollars, which is what you are really losing without this great wealth system that has been around for over 40 years.
Al Aiello is a national speaker specializing in Wealth Protection teaching dynamic strategies on tax reduction, IRS audit-proofing, entity structuring and asset protection targeted for real estate investors and business owners. Al Aiello is a regular guest speaker at CT REIA. Go here for the current list of upcoming real estate investing seminars in Connecticut.