Accelerated Depreciate for Landlords-ZT

Whether you do taxes yourself or use a tax pro, you should at leastconsider accelerated depreciation, particularly now that software makestracking and calculations easier. "It's an overlooked tax deduction,"says Stephen Fishman, author of Every Landlord's Tax Deduction Guide (Nolo, 2006).

Evensome relatively sophisticated investors miss out, says James Wittmer,head of Grant Thornton's "cost segregation" practice--a fancy name forprofessionals who charge $5,000 to take your buildings apart like ajigsaw puzzle, down to the electrical wiring, to maximize depreciation.

Lastyear Wittmer's unit helped a Texas investor who bought eight apartmentbuildings in 1989 deduct an extra $168,000 by finding $370,000 worth ofmissed short-life deductions. (You're allowed to recoup these misseditems in one fell swoop, without filing amended returns.)

Bewary, however, of segregators who work on commission--they have abuilt-in incentive to inflate your deductions, Wittmer says. And theInternal Revenue Service knows it.

Many CPAs believe thataccelerated depreciation isn't worth the hassle for small landlords.And the risk of an audit is only part of their leeriness. A big reasonis that after interest and other costs, many small landlords don'treport a taxable profit anyway. And claiming more depreciation toproduce a loss doesn't help them. That's because most high earners canuse "passive" real estate losses only to offset passive income (say,from profitable rentals) and not to reduce tax on income from theirsalary or stock and bond investments.

Still, there are twoimportant exceptions to those passive-loss rules. First, if yourmodified adjusted gross income is below $100,000, you can use up to$25,000 in passive losses from your properties to offset other incomeof any type. Up to $150,000 in AGI, you'll be allowed to claim part ofthe $25,000.

Second, if you or your spouse "materiallyparticipate" in the management of the properties and can prove to theIRS that one of you is a real estate professional, you can deductunlimited losses from real estate against any family income. (That'sthe sweet spot Kelly found.)

The other problem with accelerateddepreciation is that it defers, not eliminates, tax. So the additionalwriteoff you claim in year 11 is a writeoff you're not claiming in year26. Moreover, if you sell the building at a profit, all the accelerateddepreciation is "recaptured" back into ordinary income and taxed atrates of up to 35%. (The straight-line portion of the depreciation getsrecaptured and taxed at 25%; further profits get the 15% long-termrate.) If you flip the property, all the fancy footwork with thecomponents gets you only a modest interest-free loan from thegovernment.

But there's a big exception that can make accelerateddepreciation more valuable, not less. If those blinds you depreciatedover five years have since been replaced, you don't have to recaptureany prior depreciation claimed on them.

If you decide to useaccelerated depreciation, can you do it yourself? Narinder Sandhu andPankaj Shukla, who left jobs developing payroll and accounting softwarefor Intuit (nasdaq: INTU - news - people )to build the Depreciate'em Web tool, think so. Their service works likethis: You start with your closing statement and check off whether youhave such items as a high-end stove, kitchen cabinets, ceiling fans.The program tags each asset with the right life span. You can plug inthe actual cost for an item, if you have a receipt (or can get a copyof one from the previous owner), or pick among price ranges thesoftware generates based on national market surveys.

For itemswhere construction costs vary by region--say, a gravel driveway--theWeb tool gives you tips on how to look up a realistic cost. Then, itcalculates depreciation and spits out a "Depreciation and Amortization"Form 4562 to attach to the Schedule E of your tax return. Depreciate'emis free--for now--but the owners plan to start charging for it, likelyby this summer.

One caution: If you're audited, you'll need toshow support for your estimates. If you can't get receipts from theprevious owner, take pictures to document the high-end appliances orfancy shrubs you're writing off.

Why might you need professionalhelp? Which category something fits into isn't always cut-and-dried.The IRS arms its auditors with a Cost Segregation Audit TechniquesGuide. (You can read it at the "Businesses" section of IRS.gov.) As theguide notes, there have been many (and sometimes conflicting) courtdecisions on the classification of property. Most relate to commercialproperties but can also apply to residential rentals. An appendix listssome real examples: The hanging lanterns and chandeliers at a Shoney'srestaurant are five-year property, recessed bed lighting at a hospitalis a 27.5-year property, and spotlights and flood lamps can be either."Welcome to the IRS confusing the ---- out of people," says GrantThornton's Wittmer.

Another source of help: Publisher cch just put out a how-to book on the subject: Practical Guide to Cost Segregation, by Paul G. Di Nardo.

Remember the deductions

Manysmall landlords miss a lot of deductions that have nothing to do withdepreciation, says Scott Brueggeman, founder of Completelandlord.com,which offers online deduction tips. "One of the biggest things andleast glamorous part of being a landlord is the recordkeeping," hesays. But it can pay off.

Deductions for landlords:

48.5 cents a mile for trips to your rental property or the hardware store.

A cell phone used exclusively for your landlord duties.

Lease forms, tenant credit checks.

Interest on credit card purchases of items for your property.

Startup expenses, including insurance premiums (but not title insurance).

Advertising for vacancies, including the cost of building a Web site.