Taxes are always top of mind this time of year. But shouldn’t tax mitigation be top of mind year round? It’s shocking how little attention most investors devote to tax planning within their investment portfolios. Last time I checked, a dollar saved in taxes is a just as valuable as a dollar earned.
It’s not a coicedence that those that can most afford to ignore the effect of taxes on their returns – the uber-wealthy – are laser focused on tax reduction investment strategies. This is why some very wealthy people LOVE mobile home park investments, as they are remarkably tax efficient.
Mobile Home Park Investing = Accelerated Depreciation
Mobile home park investing offers investors accelerated depreciation relative to other real estate investments. Mobile home park improvements (utility lines, roads, etc.) are often allocated 50-75% of the total purchase price for tax purposes. These items are depreciated over a 15 year schedule vs 27.5 years for apartment buildings and 39 years for commercial buildings.
Therefore, not only do mobile home parks generate outsized cash flow returns, but most of this income is tax “free”. When the infrastructure is fully depreciated the basis can simply be transferred to another asset via a 1031 exchange. Of course, if the property is sold, capital gains and depreciation recapture taxes (25%) would be owed, but at lower rate than many investors’ marginal tax bracket. The ability to depreciate a productive and appreciating asset is sweet deal; but the accelerated depreciation afforded to mobile home park owners is an absolute gift from the government.
Value Allocation to Determine Depreciable Basis
The large percentage value allocation to infrastructure vs. land is a bit counterintuitive as a mobile home park investor owns the land and leases it to mobile home owners. Of course there isn’t much wear and tear associated with dirt, so land isn’t depreciated. However, for parks not located in crazy high land value markets (I’m looking at you California), the majority of a mobile home park’s value can be allocated to its infrastructure.
Take for an example the following Mobile Home Park component valuation and depreciation schedule calculation which is fairly typical of a smaller (50-75 pads) park in the markets my firm targets:
The land on this property accounts for 30% of the overall value. Hence the depreciable basis is $700K. At a blended 15.25 year schedule, the straight line depreciation per year is $45,902 or a hefty 4.6% of the purchase price.
Protecting Yourself From an IRS Audit
Bear in mind, real estate value allocation is fairly subjective. Consequently, mobile home park investors need to ensure they have sufficient evidence to support component valuation assumptions in case of an audit. This evidence might come in the form of a property tax assessment, which breaks out the value of the land, or perhaps via land sale comps (value per acre). To further support their allocation, a mobile home park owner can commission a cost segregation study, which is a detailed 3rd party’s opinion of the allocated value and should help resolve an IRS inquiry.
Mobile Home Park Investing = Substantial After-Tax Cash Flow Returns
Here is the tax impact of the accelerated depreciation schedule from above on the same hypothetical property:
This sample $1mm mobile home park generates $47K in cash flow after debt service. With a 25% downpayment, this equates to a 19% cash on cash return. Thanks to the benefits of depreciation (with a little help from the interest deduction) the owners of this asset only owe Uncle Sam $5.8K in taxes, which results in a 17% after tax cash flow return. Not too shabby.
Keep in mind, this is a year 1 cash flow return, which doesn’t include the benefits of loan principal reduction nor does it account for any assumed appreciation (rent increases, occupancy improvements, etc.). This puts a mid-20% IRR over the investment hold period well within reach and is precisely why we love mobile home parks – if we do nothing to improve the park (highly unlikely) we are already well ahead of the game on an after-tax return basis.
Most real estate investors focus on the gross (before tax) investment returns when evaluating investments. However, the ultimate goal should be to maximize net (after tax) proceeds. After all, you cannot live off of before tax returns – unless you enjoy speaking with IRS agents – and its not how much you make, it’s how much you keep.
To be honest, I’m guilty of focusing on before tax returns as well. But I have a pretty good excuse – when your business is mobile home park investing, taxes are not a significant drag on returns.
What are your thoughts?