The Scene:
Amber just met Vinny an hour before, but was struck by his claim that he pays zero in taxes despite making a gigantic income. Vinny agrees to share his tips if Amber buys him lunch at the fanciest Italian restaurant in town.
“The Holy Grail of loopholes is depreciation.” Bits of tomato flew out of Vinny’s mouth, but he didn’t seem to care. “You know what that is?”
“That’s the amount something goes down in value, right?”
“You got it. Except it’s a myth.”
“How?”
“Say you buy yourself a car for business. According to the government, it depreciates evenly over five years. Meaning a $20,000 car should be worth $16,000 after one year, and after five years the government says it should be worth nothing. That’s a load of crap. You’d be lucky as hell to get $16,000 for it after the first year, but after five years, it’s still might be worth $5000 or more.”
I thought of the 9-year-old car I’d briefly owned. It hadn’t been expensive, but even with the dented side, it was hardly free. “So you’re saying there’s platonic depreciation, and then there’s actual depreciation.”
Vinny tugged at his collar. “I’m Italian, not Greek. What the hell do you mean by platonic depreciation?”
“There’s an assumption and then there’s the reality, and they’re not the same.”
“Now you’re talking my language. They’re nowhere near the same. But for purposes of taxes, we use whatever number the government gives us, whether it’s accurate or not. Remember, they make the rules…”
“And we play the game.”
“You got it. So back to our car example.” He served himself some arugula salad. “If your business is making $50,000 a year and you depreciate the car at $4000 a year, then you pay taxes on $46,000 for each of those five years.”
“So it’s not that you reduce your taxes by $4000, you reduce your taxable income by $4000?”
“You got it. So maybe you save $1000 or $1500 on taxes.” Vinny picked up a sliver of parmesan and popped it into his mouth. This guy wasn’t classy, but I wasn’t here to date him, so I didn’t care.
“OK, so you get some financial advantage if the government thinks something is tanking in value, but is that enough to make a killing on? Even if the car didn’t go down a full $4000, it probably still went down by the $1000 or $1500 you’re saving out of pocket. So how does that help?”
“Ah, but what if it’s not going down in value? What if it’s going up?” He jabbed a slice of prosciutto with his fork and laid it on his plate. “Let’s say you bought a classic car for $20,000, and after five years, it’s worth $25,000. Then you’d be saving on taxes and making money at the same time.” Vinny grinned as he cut into the ham.
“So is that what you’re into? Classic cars?”
“Please. The classic car market is tiny. There’s a much bigger arena where I make my dough.”
“What’s that?” I asked.
“Real estate.”
“Real estate depreciates?”
“You got it. Over 27.5 years for residential and 39 years for commercial. Don’t you love those numbers? It’s like they drew them out of a hat.”
I grabbed a piece of prosciutto before Vinny finished it off. “Don’t properties usually go up in value?”
“You got it. That’s what makes depreciation the Holy Grail of loopholes. I can be making a killing on a property and still owe zero taxes on it. Better yet, I report it to the IRS as a loss and use it to offset other income.”
“What if the IRS catches you doing this?”
“Catch me? I rub their noses in it. It’s not like I’m making this stuff up.” His voice boomed. “I’m using their freakin’ laws.”
“I’m not getting the numbers here. If I take the cost of an investment and divide by 27.5 years, I can deduct less than 4% a year. It doesn’t seem like that big a deal.”
“It’s 3.63% to be exact, and the math gets worse before it gets better because the land the property is on doesn’t depreciate at all.”
“So how are you saving all this money?”
“You ready to be blown away? You seem to like numbers, so let me walk you through a deal I did a couple of months back. I bought a building with 14 apartments for $1,200,000. You know how much it cost me out of pocket?”
“How much?”
Vinny leaned in and whispered. “Nada.”
“How’d you manage that?”
“OPM, baby!” Vinny downed the last of his wine. “Hey, beautiful,” he called to a passing waitress passing, “can you fill me up?”
I forced my eyes not to roll. “What’s OPM?”
“Other people’s money.”
“Who’d pay for you to buy a building?”
“$1,000,000 came from the bank at 4.85% interest. Most only get 70-75% on a building like that, but I’m a good customer at my bank. I got seller financing for $150,000 at 8% interest, and for the final $50,000, I took out a private money loan from a guy I know at 10% interest. So it didn’t cost me a bent penny.”
I scribbled the numbers into my notebook. I was missing something, and I wanted to be able to go over the numbers again later. “What does that have to do with depreciation?”
“The land was worth about $200,000, so I acquired $1,000,000 in depreciation for nothing.”
“Wait, you can depreciate what you never spent?”
“You got it. Other than the land, you can depreciate it all, whether the purchase money came out of your pocket or not.”
I took out my phone and pulled up the calculator. I divided $1,000,000 by 27.5 and got $36,364. “You’re telling me you can make over $36,000 a year on this property without owing any taxes on it?”
“A hell of a lot more than that.” Vinny served himself the last of the salad. “The building brings in an income of about $150,000. From that, I can deduct maintenance costs, property management, repairs, even the interest on the loans. After all that, I’m left with around $50,000 a year. Not bad for a building that costs me nothing.”
“I still don’t see how you can avoid paying taxes. If you’re making $50,000 and depreciating $36,000, isn’t there still $14,000 left of taxable income?”
“You’re a smart cookie, you know that? Just how serious are things with this boyfriend?”
“Very,” I said, making sure Vinny didn’t get any ideas.
The main dishes arrived. Vinny breathed in the steam coming off his veal. “I love this place. They’re the only ones who know how to prepare veal like my mamma.”
I took a bite of the chicken parmesan. It was good, but my face hardly bore the signs of elation on Vinny’s.
Vinny took ten bites before he looked up from his veal. “Sorry, what was the last question?”
“How can you avoid paying taxes if you have $50,000 of profits on the books and can only depreciate $36,000?”
“Ah,” his eyes lit up. “When I buy a building, I wind up with a lot more than just walls and ceilings.”
“Like what?”
“Like furniture, lighting, appliances, cabinets. Most people lump all that stuff together with the building costs. But if you separate it, that other stuff mostly depreciates over 5 years, instead of 27.5. That’s called a cost segregation.
“To keep the numbers round, let’s say the land was worth $200,000, the building $800,000, and all that other stuff $200,000. Now what’s my depreciation? Plug that into your phone and see what you get.”
I was already entering it. The $800,000 still depreciated over 27.5 years, so that gave me $29,090 for the building component. For the next bit, I didn’t even need my calculator. $200,000 divided by 5 years is $40,000 a year. Adding those together, I got “$69,090. Wait, but that means you have more depreciation than you’re making.”
“Exactly.” He rubbed his hands together like a movie villain. “So not only does the depreciation knock out the entirety of my $50,000 in profits, it knocks out another $19,000 from other properties.”
This sounded too good to be true. “You can use depreciation from one building to offset income from other sources?”
“You never appreciated the beauty of depreciation before, did you?” Vinny took a bite of his veal, showing an almost indecent amount of pleasure.
“You ever worry about having too much depreciation?”
“Absolutely. The total amount I get is fixed. It’s not like the IRS will send me a check if I have more depreciation than income, so I don’t want to waste it. I keep a close eye on how much depreciation I need. I only do cost segregations when I have enough income to offset. If I didn’t have enough when I bought this last building, I could have let the entire $1,000,000 depreciate over the 27.5 year period. Then, if there came a year when I needed more depreciation, I could retroactively separate out the furniture and stuff.” Vinny popped a scallop into his mouth.
“You don’t need to do the cost segregation when you buy?”
“Nope. And in the year you do the segregation, you get to pile on all that extra depreciation from the years you missed. Using our numbers, the segregation gave us an additional $33,000 a year in depreciation for the first five years. Let’s say I didn’t need that deduction in the first two years, so I waited until year three. In addition to the $33,000 coming to me that year, I can add $66,000 from the two years I missed.”
“You’d be able to offset almost $100,000 worth of income?”
“Ain’t it great?”
“But it’s not like the segregation increases your depreciation, you just use it up faster.”
“The total is the same, but why wait 20 years to get my money?” It was hard not to get distracted by the piece of veal on the end of his fork. “The cash I have in hand now I can use to buy more properties. It’s compounding at a mad rate.”