Much has been made about changes to the tax code arising from the Tax Cut and Jobs Act (TCJA) passed into law in late December of 2017. The TCJA preserved and enhanced many of the tax benefits associated with real estate investing. Depreciation is one of the strongest benefits. Understanding what depreciation is, the various types of assets, how depreciation for those assets differs and finally how depreciation is captured and recaptured for tax purposes plays a vital role in tax and investment planning.
The IRS has assigned a default useful life for real estate assets – generally 39 years. Those assets are assumed to depreciate or decline in value for tax purposes over a straight line from the date of acquisition to year 39. Depreciation is treated as an expense and reduces the amount of taxable income a property earns during any given year.
Some managers and sponsors take a more granular look at their properties to identify assets that have shorter useful lives than the land improvements and structure itself. Those assets, if properly identified, can also be depreciated over their shorter IRS-established useful lives, thus increasing the reduction in taxable income.
Managers identify these assets through a process called cost segregation. A trained professional will evaluate the assets in a real asset and determine which assets have a shorter useful life than the structure itself. These may include items such as new carpet or fixtures, a roof, lot improvements and many others. This cost segregation analysis effectively increases the value of the depreciation tax benefits. This is especially powerful when combined with bonus depreciation.
Bonus depreciation allows an owner to accelerate and deduct depreciation for any asset with a useful life of less than 20 years in the first year. The TCJA included a gift for real estate investors when it increases bonus depreciation from 50% to 100%. The highly simplified example below highlights how these benefits work together to save tax expenses in the early years of a real estate investment:
- A sponsor purchased a property with 100% cash equity for $6M.
- A cost segregation analysis identifies $4M of 39-year useful life (Land and Structure) and $2M with <20-year useful life.
- Assumes an individual income tax rate using the Qualified Business Income deduction of 29.6%
In this example using bonus depreciation and cost segregation generates more than $500,000 in tax benefits over a 5-year period. The tax benefit in years 2 through 5 are lower when using bonus depreciation. This occurs because depreciation has been accelerated into year 1 using the bonus depreciation benefit.
This last point brings us to another important note: Depreciation and bonus depreciation is not a tax eliminator but a tax delayer. When a property is sold, the IRS hasn’t forgotten about the tax benefits you’ve received along the way. They are waiting to recapture those gains. At the time of the sale of a property, depreciation is recaptured as profit and will be taxed at that time. Again, an example will help illustrate the point:
- This same property that was purchased for $6M is sold for $7M at the end of Year 5.
- Assumes the same 29.6% ordinary income tax rate and a 20% capital gains tax rate
While this does require cash and tax planning with your CPA, most investors prefer to delay their tax obligations wherever possible. Deferring $500,000 in taxes as shown in this example is a tangible benefit to investing in real estate.
Fairway America’s investment products (funds and single-asset syndications) benefit from these and other real estate specific tax advantages. As you consider your tax obligations this year and your investment plans, discuss with your CPA or tax preparer the benefits associated with real estate investing and how those might fit into your investment needs.
About the Author:
John Wilson joined Fairway after spending nearly two decades at Intel, where he managed a billion-dollar construction and tooling budget for a new manufacturing facility, led the financial planning and analysis activities for Intel’s largest division, and founded Intel Federal – a startup division dedicated to working with the U.S. Federal Government on supercomputing leadership. John was also tapped to lead various councils for leadership development, training, and recruiting, and others.
As Fairway’s Chief Financial Officer, John is responsible for overall treasury functions, financial planning and analysis, and leading the investor relations team. John holds an MSM (MBA) in finance and marketing from Purdue University Krannert School of Management as well as a BA in English from Brigham Young University.