“But in this world nothing can be said to be certain, except death and taxes.”
It’s never fun to pay a big portion of our hard-earned money to the government each year, but it is everyone’s duty to pay appropriate taxes. Having said that, the IRS has in place many advantages that the real estate investor can participate in. This is to encourage investment and improvement in communities that benefit the society and the people. This is one of my favorite aspects of real estate. There are many tax advantages, but for this discussion, we will explore two – depreciation and the 1031 exchange. When implemented correctly, the investor can effectively pay very little to no taxes.
For a normal transaction, let’s say that an investor buys a property for $300,000 in cash. She makes $10,000 in cash flow each year. After 5 years, she sells for $400,000. She will be responsible for $10,000 x 5 years at her tax rate. Let’s assume that she’s at the 32% tax bracket. $50,000 X .32 = $16,000. Then on the sale, she had $100,000 in gains. She’d have to pay capital gains tax, which is 15-20%. Let’s say that she’s in the 15% bracket. She’d pay $100,000 x .15 = $15,000. For the 5 year project, her total profit would be ($10,000 x 5) + $100,000 = $150,000, and she will pay $31,000 in taxes, or about 20.7%
Let’s take a look at depreciation. With depreciation, we can effectively eliminate the cash flow taxes above. Technically, it’s not eliminating, but in practice, we can effectively end up not paying taxes on the cash flow.
Depreciation is where a business asset has a finite lifespan, and each year, the owner can deduct the depreciation of the asset against any profit that he/she makes for the year. Let’s say that a farmer has a tractor that he bought for $100,000. He expects to use it for 10 years. In this case, he will depreciate $10,000 each year, and deduct that from his profit for the year. In the same way, the real estate investor can consider her building a business asset, and depreciate it over the designated life span of 27.5 years. The investor can only depreciate the building and its components, and not the land. In the above scenario, let’s say that the land value is $25,000. Then, she can depreciate $275,000 over 27.5 years, or $10,000 per year. She can then deduct $10,000 of taxable income from her cashflow per year. Her annual cashflow was $10,000, so the depreciation will bring down her taxable income to $0!. Now, unlike the tractor which actually depreciates over time, the building that the investor owns appreciates over time! While the market value of the property is appreciating, for tax purposes we can depreciate the building and deduct our taxable income! It sounds too good to be true, but it is legit and recognized by the IRS. Now, the depreciation is recaptured on the sale. What this means is that if the investor depreciated $10,000 over 5 years, that $50,000 depreciation is added when she sells the property. In the above scenario, when the investor sold the property for $400,000, she realized $100,000 in gains. When she recaptures the depreciation of $50,000, her gain is now $150,000. But you will notice that the 15% capital gains tax rate is lower than that of the ordinary tax bracket of 32%. In this case, our investor will end up paying a total tax of $22,500 over the course of the investment, or 15%. This is a quite a bit of improvement from the $31,000 we paid in the first scenario.
Now, let’s take a look at the 1031 exchange. The IRS allows the investor to defer their capital gains tax when she engages in a “like kind” exchange and abides by the requirements set forth by the internal revenue code 1031. To say that in English, when an investor buys an asset and sells for a profit, she realizes a gain, and must pay capital gains tax. With the 1031 exchange, the investor can roll all her profit tax free into the purchase of a new property if she complies with the requirements outlined in the internal revenue code. Technically, the tax is not forgiven, but deferred, and it will be recaptured later, similar to the depreciation example above…. Or will it??
Let’s use the same example where the investor buys a $300,000 property and then sells for $400,000. She has to pay capital gains tax on $100,000. When she does a 1031 exchange, she can take the entire proceeds from the sale and buy a new property(of equal or greater value) tax free. The $100,000 gain is deferred and will be recaptured when she sells the next property. But she can also do 1031 for the next property, and then again and again in perpetuity. Therefore, in theory she can end up never paying taxes. And when she passes the property down to her heir, the tax basis resets and the heir would not be responsible for all the accrued taxes. It is a tremendous advantage for the real estate investor, but there are many changes that are being demanded of it, and it may not always be available.
For the 1031 exchange, there are many requirements that need to be met. The investor must identify 3 candidate replacement properties within 45 days of selling her property. Then within 180 days of selling her property, the investor must buy the replacement property. If the timelines are not observed, the 1031 is considered void and the investor will end up paying capital gains. This can put some pressure on the investor to find and buy something, or anything. One must be careful to not get pressured into buying a bad deal due to time pressure. It can serve well to start looking for the replacement property well before initiating the sale of the disposing property. The replacement property must be of equal or greater value than the disposed property, and the loan on the replacement property must be the same or greater than the disposed property. All of the sales proceeds must be contributed to purchasing the replacement property. The investor also has to involve a QI(qualified intermediary) to handle the money. The investor cannot touch the funds or have it deposited in her account at any point during the process. The QI must receive, hold, and distribute the funds in order to comply with the 1031 requirements. They will do this for a nominal fee, and one can find many QI’s through online searches and also through referrals from other investors.
Now, let’s see what happens when we combine depreciation and the 1031 exchange. The investor can deduct $10,000/year from the cash flow where she pays $0 income tax on them. Then when she sells in 5 years, the $50,000 depreciation gets recaptured. By executing the 1031 exchange, she defers all of that gain until the sale of that next property, so she ends up paying $0 in taxes until she sells. Then when she sells, she can do another 1031, and again, in perpetuity. Finally she can pass down the property to her heir and the taxes will be effectively reset for the heirs! The investor can effectively and legally end up paying 0 taxes on her real estate investment!
Now, the smart investor may think that if we keep doing the 1031 exchange, we can never sell and realize our profit. Fortunately, this is not true. The investor can get the income from cashflow each year tax-free, and also get the money out by doing a cash-out refinance on the property, and more than once if desired. Then those funds can buy more properties where she can do the above all over again. It’s not hard to see that this is a powerful strategy in growing one’s portfolio exponentially.
There are advanced strategies where the investor can do what’s called an accelerated depreciation(by doing a cost-segregation study) where she can front-load the depreciation schedule to deduct large amount early in the project. There is also the reverse 1031 exchange where the investor can buy the replacement property before selling the disposition property. A savvy investor can optimize her taxes and possibly end up paying low to no taxes on her investments. Real estate can be an amazing tool for building wealth.
Note that the author is not an accountant nor a lawyer, and the above content is for informational use only, and they are not legal/financial advice. Always consult your attorney and accountant.
By: Ki Lee