With April now behind us, and tax season closed, it’s never too late to dive into the tax benefits of real estate and how you can set yourself up for success come tax season 2024. Before diving into the tax benefits of real estate, let’s talk briefly about the purpose of taxes. The tax code is obviously written with the intent to levy a tariff on you and me, but it also tells us what activities the government is incentivizing or encouraging. Finding tax benefits or tax incentives within the tax code are indicators of economic activity the government (local, state, or federal) is encouraging. Part of any investment strategy each year should include relating investments to what the government is incentivizing via the tax code in order to receive the maximum deductions allowed.
To be upfront, volumes of books and entire careers are dedicated to helping investors maximize the value of their investments by paying as little tax as legally and ethically allowed. At Belz Living, we are simply exposing investors to possible tax strategies within their real estate investing portfolio. This is not professional tax advice.
Let’s focus this article with a popular strategy among real estate investors: the cost segregation study. A cost segregation study or ‘cost seg’ divides up an asset into various categories that can be depreciated at different times on different schedules. Typically, most investors depreciate their real estate investments on the 27.5-year or 39-year straight-line schedule. Using this method is analogous to cutting a stick of butter with an ax. A cost seg study, when performed by a professional service, provides a much more detailed analysis of the property by dividing the asset into four structural components: personal property, land improvements, structures and buildings, and land assets. By dividing the structural components of the property and reclassifying them, they are put into shorter depreciation periods. Personal property (appliances, carpeting, furniture, etc.) are depreciated over five to seven year periods, while land improvements (landscaping, paving, sidewalks) are depreciated over a 15 year period. The physical structure is depreciated at 27.5 years (residential) or 39 years (commercial) while land assets are not depreciated at all. The conclusion of this study serves as the basis for calculating accelerated depreciation during tax season. It also provides the justification should accelerated depreciation fall under the scrutiny of the IRS. The benefits of this study allows investors to maximize the deprecation of their real estate asset by frontloading deprecation deductions against any passive income filed for that tax year.
Now, armed with the knowledge of a cost seg study, let’s look at a practical example: say an investor purchased a building for $1,500,000 and then sold for $2,000,000 a few years later. Many would think the capital gain is $500,000. However, the gain is the sales price minus the adjusted basis of the property. If the property was purchased for $1,500,000, but depreciated over the period of ownership by $500,000, the adjusted basis of the building is actually $1,000,000. Since the building sold for $2,000,000, the taxable gain is actually $1,000,000. $500,000 from property appreciation and $500,000 from depreciation ‘recaptured’ by the IRS. This tax from Uncle Sam is aptly named a depreciation recapture tax. Property appreciation is taxed as a capital gain (0%, 15%, or 20%) while deprecation recapture tax is taxed up to 25%.
Of the many reasons to conduct a cost segregation study, here is the strategy we attempt to implement at Belz Living: frontload depreciation by hedging your tax benefit against inflation. The alternative is using the 27.5 year straight-line depreciation. Using the straight-line method against a building worth $500,000 results in a $18,181 annual deduction. That $18,181 is worth significantly less in real dollars 27.5 years from now, especially considering a high inflationary environment. Taking advantage of the bonused depreciation upfront allows us to trade a real estate asset using a 1031 exchange. The 1031 exchanges allows investors to defer both the capital gains tax and depreciation recapture tax at the sale of the property as long as the proceeds are invested into another “like-kind” property.
The two tactics mentioned above (cost seg and 1031) not only take advantage of bonused appreciations purchasing power multiplier, it eliminates the taxable event that would trigger a 20% capital gains tax and a 25% depreciation recapture tax! These strategies must work with both one’s investment goals and risk appetite, but unlock incredible wealth building potential to those who navigate it appropriately.
