Find Cash: Repair Your Properties—Don’t Improve Them

Let’s visit your business or rental building.

Here’s a fact: the repair deduction is worth far more after-tax cash than a depreciation deduction.

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Depreciation Deductions—Strike 1

The depreciation deductions allowed on business or rental buildings are not in the same league with real deductions. Why not?

Recapture taxes!

To the extent of gain on sale, you pay a special capital gains recapture tax of up to 25 percent of the straight-line depreciation you claimed on a building. Technically, the law considers this recapture tax on your straight-line depreciation to be a tax on net long-term gain attributable to “unrecaptured Section 1250 gain.”

Example. You depreciated your office building by $50,000 using straight-line depreciation. You now sell the building at a profit of $200,000. Your federal taxes are 15 percent on $150,000 and 25 percent on $50,000.

Your $50,000 of straight-line depreciation did not produce a true deduction. Instead, it produced a likely profit sharing loan of the deduction, with payback to the IRS tied to the gain on sale.

You may or may not realize any benefit from the “profit-sharing” part. If your tax-benefit rate during your ownership period is 25 percent or less, you received no profit-sharing benefit.

On the other hand, if your tax-benefit rate is greater than 25 percent, you do participate in the sharing of profits with the government. But this minor sharing achieved by being in a tax bracket greater than 25 percent does not give you a reason to fall in love with depreciation.

Key point. Repairs outperform depreciation.

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Depreciation Deductions—Strike 2

Depreciation comes in small bits and takes time. Tax law grants your real property building (not land) depreciation deductions on a straight-line basis over

• 27.5 years for residential rental property, and
• 39 years for commercial property.

Example. You are going to spend $30,000 on fix-ups to the building that houses your business. If you are in the 28 percent tax bracket and you do this as a repair, you pocket $8,400 in after-tax cash when you spend the money.

Technically, you pocket the cash either

• when you file your tax return and reduce the amount you pay to the government, or
• in the case of refund, when you receive your tax refund.

For a capital expenditure, you depreciate approximately $769 a year for 39 years, pocketing $215 a year (28 percent x $769). If money is worth 6 percent to you after taxes, the $215 collected annually for 39 years is worth $3,412 in today’s dollars.

Using only the time value of money, the repair deduction in this example is 246 percent more valuable than the depreciation deduction.

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The Combination—Strike 3

Say you sell the building and have to pay the recapture tax on the $30,000. That 25 percent tax is 10 percent greater than the 15 percent capital gains tax. Thus, at the end of year 39 when you sell the building at a nice profit, you pay a recapture tax of $7,500 on your unrecaptured Section 1250 gain.

Let’s say that the repair would have had about the same impact on the future value of the building. With the repair, your capital gains tax on the $30,000 would have been $4,500.

Thus, with the repair, you are ahead of the game by another $3,000. However, that $3,000 is 39 years in the future.

You need to “present value” that $3,000 to today’s value of $309. Subtract the $309 tax payout from the $3,407 depreciation benefit and you have a net benefit of $3,098.

In today’s dollars, the repair in this example is 271 percent more valuable than an improvement. That’s a lot. It’s certainly something you need to consider in the repair-or-improvement equation.

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Repairs Are Best

We used a Rental Property Analyzer to analyze the repair scenario. Using the default, we changed the $30,000 down payment to repairs in Year One, and then adjusted the land and selling prices to reflect the original defaults so that the only change was making the down payment a repair.

On the seven-year holding period, when the passive loss rules did not apply, the annual rate of investment return jumped 37.6 percent, from 14.45 percent to 19.89 percent. This is a goodly increase in a seven-year time period.

What if the passive loss rules precluded annual deductions for losses? When we kept the numbers the same as those above and flipped the switch in the Rental Property Analyzer to put the passive loss rules in force, we found that the rate of return increased by 17 percent, from 12.7 percent to 14.9 percent.

Thus, even with no current deduction, you come out ahead with the repair.

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Takeaways

The after-tax cash value of repair deductions significantly outweighs the depreciation deductions on business or rental buildings. Why? Recapture taxes reduce the benefits from depreciation deductions.

Another disadvantage of depreciation deductions is that they are granted over extended periods: 27.5 years for residential rental property and 39 years for commercial property. In contrast, you can (depending on the passive loss rules) receive the tax benefits of repair expenses almost immediately.

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