FAQs to the CPA

We encourage every investor to do their due diligence on any new tax strategy they might possibly employ. National Chattel Experts partners with Warren Taryle, CPA to provide basic answers to some of themore common CPA questions.

**The following is not tax advice and should not be intended as such. Always consult with a tax professional regarding tax tools or strategies and your unique financial situation.**

Q. If a property is re-evaluated with a portion of the property being “personal” property how does that effect a 1031 exchange going into the property, i.e. will the full purchase price still be used to qualify for the exchange into this property?

A. If a property is reevaluated with a portion of the propety being “personal” property, there is no effect on the purchase price.

Q. If a portion of the property is designated as “personal” how is it handled when the property is sold? Is the accelerated depreciation recaptured?

A. All depreciation is recaptured, not only what has been acellerated.

Q. Is there a reduction in the “value” of the real estate at the time of re-sale by the “personal” amount, so there would be a lower value being exchanged out?

A. Rules for a 1031 exchange and the rules for personal property are two completely different sections of law. There is no problem with doing a 1031 exchange as though the personal property had never been segregated.

Q. How is the “sale” of the “personal” property handled, if you have a 5 year depreciation schedule and sell the property in 3 years?

A. In this scenario, if you sell the property after three years of ownership and are in the midst of acellerating depreciation, the depreciation (accruing to date) is subtracted from the basis of the property, and this determines the gain.

Q. What if you employ the 5 year depreciation schedule and then sell the property in 7 years?

A. If you have fully depreciated your property, there is no basis left at all. This means that everything else would be considered a gain.

Q. What happens if I accelerate depreciation, sell the property in two years, and then 1031 into another property? As I understand it, the basis for my new purchase equals the purchase price of the first property less the depreciation I took, despite the purchase price of the new property.What happens with the basis if I sell one property and buy two?

A. The basis in the new property is basically the purchase price of the new property less the gain that is being deferred on the original property. In buying two properties, we would allocate usually based on purchase price the differed gain to the two new properties.

Q. I need some information about the court case referenced as the basis for commercial cost segregation, Hospital Corporation of America vs. Comm. (109 TC 21(1977)). Hospital Corporation of America had to do with that Tennessee-based hospital which was charged with one of the largest fraud cases in history. What does this lawsuit have to do with the resulting segregation of personal property? Can you explain the history and the link between the fraud and depreciating personal property? Why would they rule that we can separate 1245 property from 1250 property?

A. The case has nothing to do with fraud as far as I know. Specifically, Hospital Corporation of America vs. Comm. (109 TC 21(1977)) allowed us to separate personal proeprty from real proeprty. 1250 property is real property and 1245 property is personal property. All CPAs should know the difference between the two. The big deal is that in separating the two, we could then value the personal property. This, in turn leads to being able to cost the property separately.

Q. If someone decides to turn their primary residence into a rental unit: 1) When can they begin to accelerate depreciation? Is this a “change in accounting method?” 2) What happens on the CPA-side when a unit goes from owner-occupied to non-owner occupied? 3) What other information do we need to know to speak about this topic to a potential client?

A. When a property is converted to a rental it is as if it was purchased that day and depreciation begins. It is not a change in accounting method because we did not have an accounting method before it was a rental.

As far as chattel appraisals go you would do an appraisal based on what the property had the day it was originally purchased. The property owner would then add to that any 5 or 15 year property they purchased while living there. No appraisal is need for that since they should have the records of what they paid for everything. This would include appliances, drapery and other high-dollar items.

Q. I was hoping for a definition for the “Residual Estimate Approach” that is referenced in the CPA to CPA letter. What is the layman’s definition/explanation?

A. The Residual Estimate Approach is where we determine the value of the 5 and 15 year property and subtract that amount from the purchase price. The remaining or “residual” value is what we assign to the value of the building and land.

The residual estimate approach is different from other methods: it is opposed to assigning value to every component of the property. This other approach assigns a value to chattel and land improvements, as well as every 2×4,every wire, pipe and floorboard in the joint. Once value is assigned to every component, that value is totaled up and compared to the purchase price.

Q. If we do a chattel for $10,000, and the client gets $15,000 in depreciation the first year, does that mean they’re really getting a $25,000 benefit? This question stems from the fact that an appraisal is tax deductible. If this is the case, then it’s definitely worth mentioning–especially for larger clients.

A. The cost of the chattel appraisal IS absolutely deductible, so you could look at it as part of the tax benefit. I just usually like to mention that on top of the benefit of accelerating the deprecation deduction, the fee is, of course, also tax deductible.

Q. Where can we find the list of 65 items the IRS calls Chattel? I’ve seen the lists in our presentations before, but am unsure of the origin of this information. Can you cite a tax code or IRS code on this for us?

A. There is no such list published by the IRS. What we work with is the definition of personal property. Under the code sections dealing with personal property, the code goes according to state law. This is not an exact quote, but personal property is defined by state law for the state in which the properties is located. Furthermore, there are no tax code sections that specifically talk about chattel depreciation. This has come about through interpretation and combination of several code sections which then were solidified by case law (See Hospital Corporation of America vs. Comm. (109 TC 21(1977)).

Q. Can you please give a simple explanation of recapture tax?

A. The “recapture” is taxed at the person’s ordinary tax rate but a maximum of 25%. So if the person sells a property and is at the 10% tax bracket, the recapture tax is going to be 10%. If they seller is at the 30% tax bracket, it would be taxed at 25% if you're working it correctly.

Q. How much rehabilitation or remodeling of an existing unit do you have to do to qualify for accelerated depreciation?

A. There are two scenarios at play here. Let’s take a look:

1) if you have done a chattel appraisal before rehabilitation: take the value determined by the appraisal for anything you replaced and write it off. For example, you are rehabbing a kitchen in which a chattel appraisal shows the appliances valued at $1,500 and counter tops and cabinets are $1,700. Assuming the rehabilitation will replace all the counter tops cabinets and appliances, we would write off the $3,200.

2) In doing the rehabilitation, we would depreciate over 5 years the cost of any chattel added in as a result of the rehabilitation.For example, say that you spend $8,000 on new counters and cabinets, $4,000 on new appliances and 3,000 on new tile flooring. We would depreciate $12,000 (8,000 + 4,000) over five years since it is chattel and $3,000 over 27.5 years since it is part of the building.

Q. What are the passive loss rules for people in the >$150k income bracket?

A. Real estate is passive activity, and the general rule is that you can only use passive losses against other types of passive income. This means that you could not use real estate losses against W-2 or business income for example. There are two exceptions to this rule, however.

If you make less than $100,000 you can deduct up to $25,000 against other types of income. As your income goes over $100,000, the $25,000 is phased out. When you get to $150,000 the $25,000 is gone entirely

The second exception is if you qualify as a real estate professional. In that case, all of your real estate losses are deductible against other income regardless of your income. To be a real estate professional you must spend at least 750 hours per year on real estate and more time on real estate than other income producing activities. And just to further clarify, there is no problem with using the passive loss of depreciation against passive gains, regardless of your income.

Q. How does a chattel appraisal affect areas like the Go Zone, where they are already acellerating depreciation for investors?

A. The Go Zone will allow an investor to deduct 50% of the purchase price of the building the year (s)he places it in service. So lets say he buys this building this year for $10 million, he would write off $5 million this year. In the next 26 years, without chattels, he would write off about $182,000 in depreciation. This calculated by taking the remaining $5 million and dividing it over the 27.5 year depreciation life. If we were to use chattel he would get the same $5 million deduction this year. The subsequent years is where chattel will make a big difference. Lets assume that we can identify $1 million in chattel. During the second through fifth years we would have about $245,000 in depreciation that is an additional $63,000 a year in depreciation which at a combined tax rate of 40% is a little more than $25,000 in extra tax savings a year for five years.