When asked recently about what one can do once they have exhausted the depreciation on their apartment building, my interest was piqued. My wife and I have been helping real estate investors eliminate the pesky bills to the IRS for over 3 years now. Prior to that you could find me in a cubicle of the PwC office building in the seaport district of Boston, MA. It was there where I found that some of the largest companies in the world, those who hold the most wealth, utilized strategies that others might not know about. These companies had money and they used that money to make more money. I began to think that if the companies could do it, so could you – the typical American investor.
Chances are you’ve acquired some real estate, or at least thought about acquiring some real estate. You’re probably familiar with the concept of depreciation and using it to lower your taxes on your real estate income. Maybe you’re even a real estate professional who is using real estate to offset your heftier income amounts from a W2 or business venture. Wherever you find yourself in your real estate journey, you want to read this. This article will outline strategies that are useful for all real estate investors. Whether you’ve purchased your first single family home or are scaling up to your next apartment building, finding ways to save on tax through real estate is crucial for all of us. If at any point you feel frustrated that you haven’t fully developed a tax strategy for your real estate portfolio, you can schedule an appointment here.
John Stiles of Apartment Cash Flow, Inc recently asked me what an investor can do once they’ve exhausted all the depreciation on their property. For the beginning investor, it might make sense to outline what this means. When you purchase a property, the IRS allows you to write off a portion of the value of that property on your tax return. This is known as depreciation expense which is calculated using the purchase price of the building (excluding land) and dividing it by the useful life of the property, traditionally 27.5 or 39 years, depending on the type of property. So, when someone asks what they can do once they’ve exhausted all of their depreciation, it usually means they’ve held the property for a while. And if that’s where you find yourself, you’ll want to keep reading. If that’s not where you find yourself, I encourage you to keep reading anyway for this will turn some lights on in your brain that have been off for a while.
1. 1031 Exchange
Many people in the real estate space are familiar with the term 1031 exchange. It is named after section 1031 of the Internal Revenue Code which allows a property owner to sell their property and defer the taxes related to the gain on the sale of the property. This strategy can be used an unlimited amount of times so long as you meet the timing requirements set forth by the IRS. The reason this is such an optimal option for someone who has extinguished their depreciation is due to what’s known as depreciation recapture tax.
The IRS doesn’t let you double dip on tax benefits. Because they know you’re capitalizing on the tax benefits of depreciation while holding the property, they’re going to want it back when you sell the property, and they do this through depreciation recapture. This is a tax on the depreciation related to the gain from the sale and it is typically taxed at a rate of 25%. If this sounds like a lot, it is. But it’s important for you to recognize that through the power of 1031 exchange, you can shield yourself from not only the capital gains rates but also the depreciation recapture rates, saving you tens of thousands, and oftentimes hundreds of thousands, of dollars in tax
2. Capitalize Improvements, Depreciate Improvements.
Okay so you’ve wrapped your head around 1031 exchanges but you’re set on not exiting the property, are you left hopeless? Not quite. Assuming you’ve exhausted the depreciation, and you want to hold onto the property, the next rock we would look under is the improvements rock.
As mentioned, if you exhausted the depreciation on your property we assume you have held it for a long period of time. This likely means it has some wear and tear that can be improved. What does it mean to improve a property? It means you take old pieces of property and replace them with new pieces. And what happens when you add new equipment or property to your projects? New useful lives.
You see, if you’ve exhausted the depreciation on your original property, it is worth considering an investment in the improvement of that property. You’ll find yourself charging more in rent, and assuming you have the right accountant, paying less in tax, through an increased depreciation expense.
So, if you’re worried about having exhausted your depreciation on the building, first consider improving the property then find the right accountant to help you understand how you can use those improvements to save on tax.
3. Refinance Your Property
Once you’ve improved the property, the value of your assets now go up. Not only do you get a greater depreciation expense as outlined in number 2, but you also get a greater asking price if you were to go and sell. Because we’ve already determined that we’re not selling, the next thing to consider is refinancing the property.
Given the beauty of the United States tax code, debt comes to the borrower completely tax free. So, when you go to refinance your property and tap into some of the equity you’ve built up, you can now receive liquidity without having to pay taxes. Our higher income clients will do this in tandem with the 1031 exchange strategy. They’ll 1031 into a property of greater value and take out a loan against that property to go and buy more properties. This strategy works great because your rent collected pays for the costs of keeping the loan and you generate more income by owning more assets. If you’ve exhausted the depreciation on your property, consider tapping into some of the equity you’ve built up through the power of tax-free refinancing.
Final Thoughts.
So, there you have it, three of our top pieces of advice to tap into the power of real estate tax free once you’ve exhausted the greatest tax benefit of all – depreciation.
If you’re reading this post, frustrated that you haven’t received any of this advice before or have just lacked confidence in your real estate decisions, find a time on our calendar to discuss your concerns with our team and discover if our services are a good fit for you.
Chris McCormack
CPA, MBA, CTP
Founder and Managing Partner
Better Books, LLC
Thanks to Chris McCormack for writing this guest blog post. You can find more information about Chris and his business: Better Books at the links below
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