to 1031 or not? Can bonus depreciation be used to generate similar tax benefits?

[Stephen Bass]

I'm working with family that is in the wind-down/retirement phase of their real estate investment careers.  They have been actively managing a few small mulitfamily homes for many years and no longer desire to be actively managing.  These properties have been owned for many years so approx. 90% of the sales price is capital gains  - let's say four properties worth approx $1M each today.  
With 1031s - DSTs seems like a possible approach since it's truly passive however returns are low.  However given the large proportion of gains I think the tax deferral is quite valuable.
I've also read that bonus depreciation (e.g., via syndication) could achieve significant losses in the year of acquisition.  Could those losses offset the gains from the sales of the properties?  Certainly won't be completely deferred/offset as with 1031 but maybe higher returns from a syndication make this worth considering?  Are we thinking through this correctly? 
Lastly, I've also read that bonus depreciation is not recognized in the state where we live (same state as where the properties to be sold are located).  Is this relevant or is the relevant factor the location of the syndication properties that would take advantage of the bonus depreciation?

Thank you in advance - so many knowledgeable people here and I've learned so much from the forum!

[David M.]

@Stephen Bass

First, you really shouldn't be giving taxation advice to --- whomever they are... sellers?

What does bonus depreciation do that 1031 won't?  The former creates more tax deferred liability.  You are just having them spend money in an attempt to trade realized tax deferred liability into tax deferred liability.

It depends on what they need/want.  I guess they haven't figured out their exit strategy?  Unfortunately, too many investors don't bother to figure that out when they start.

If you are going to get into this, See how much Passive Allowed Losses (PAL) they have banked.  People seem to keep skipping over that when being spiteful about paying taxes.

Are they mobile?  1031 into a property, rent it for a year or so, then move in.  After 2 years sell to use the sec121 exclusion for capital gains (doesn't help with depreciation unrecapture).

Yes, DST and syndications have a long running thread right now about their risks. For better or worse, 1031 seriously constrains their investing options, even for real estate. Doesn't let them even do debt investing for the cash income for their retirement.

But, still it depends if they need the cash.  What are they doing next in their retirement.  I've shown before in another real life post, it was cheaper for them to sell and pay the tax, than most any other option, even if they were still going to invest in real estate.

Good luck.

[Bill Brandt]

Bonus depreciation is simply pulling depreciation forward. That means owing more taxes in the future while decreasing the tax benefits of owning that property until you sell. So yes it will reduce the taxes owed this year but it will hurt every year in the future. It’s “probably” better than selling without a 1031 and buying without bonus depreciation, but way worse than just doing the 1031.  You’ll be under just as much pressure to buy something/anything to claim the bonus depreciation. 

[Stephen Bass]

Thank you @David M. and @Bill Brandt for your replies!  

The accumulated passive allowed losses is something that we will look into - unfortunately I don't have much faith in the CPA they've been working with but hopefully this will can be determined relatively easily.  Also need to determine what limitations (if any) apply to using these losses to offset gains.

With regard to exit strategy...the sellers are not mobile (i.e., no wish to move). They have modest cash/income needs which could be satisfied by DST-level returns but we're trying to determine if there's a better move. Satisfying the cash/income needs is a must but of course if they're able to preserve and accumulate wealth all the better.

Seems like we may just need to do some modeling...

[David M.]

@Stephen Bass sure, some modeling would help.  But, if they are obstinant / spiteful about paying the taxes it certainly will be difficult.  Its very possible they could do just as well if not better by selling out.  Its what I'm doing...

You aren't the first person in this situation.  We've had other thread recently.  They went towards trying to figure out estate planning to try to settle this.  Not sure what they ever figured out, however.

Happy to chat.  Good luck with them.

[Dave Foster]

@Stephen Bass, I'd use the 1031 plus good DST purchases to create additional depreciable basis. Since most DSTs have institutional debt that you assume (but are not liable for - called non-recourse debt) the use os $100K of cash could purchase $400K of DST purchasing power on a DST that is 75% leveraged. This could conceivably really bump up their annual depreciation write off. While still maintaining the tax deferral of the 1031.

And when you use that leverage in your purchases of DSTs you also dramatically ramp up your actual real returns on the investment. The cash payments are modest. But they are only one prong of the Internal Rate of Return. The IRR also includes depreciation write off, amortization of the loan, and appreciation of the assset while the DST holds it. Usually the IRR in a DST is well north of 10%. That is a real return.

It's not exciting and over the moon.  But the stress of worrying about real estate assets and their performance is not what reitrement should be about.

[Jack Martin]

@Stephen Bass bonus depreciation can be a powerful tool if approached correctly, and has the potential to create substantial tax benefit, which can be used to offset the gains incurred from the sale of property.

As you seek investments with bonus depreciation, keep in mind some property types will garner more benefit than others. Bonus depreciation is derived from the portion of the property's value with a shorter useful life than the buildings themselves. Therefore the property types that are the most favorable to generate bonus depreciation will be those with a high degree of what the tax code refers to as "land improvements". Examples are mobile home parks, RV parks, and golf courses where the value of the property is not primarily derived from building(s) but rather from the improvements to the land. In a mobile home park, most of the value is in the underground infrastructure, roads, landscaping, amenities, pools, fencing, pads, utility pedestals, etc, while only a small portion of the value comes from a building, like a clubhouse or laundry facility. In a similar fashion, if you can imagine how much landscaping and underground infrastructure is in a golf course as compared to the clubhouse, that will give an indication of why an extremely high percentage of the property's value is allocated to the land improvements. Properly executed, an investment in these types of property can garner substantial passive losses, often equal to the amount of capital invested (or more) even in years where the benefit begins to sunset.

A few words of caution: 

- The tax benefit is valid as long as the gain incurred from the sale of property AND the investment with bonus depreciation occur in the same calendar year. 

- Be careful not to let the "tax tail" wag the dog. Avoid investing in a poor property or poor location, simply for the depreciation benefit. 

- If you are investing passively in a syndication with bonus depreciation, make sure to vet the sponsor and understand the investment vehicle before you invest. Bonus depreciation is an incredible tax benefit, but when you take the time to combine it with the right property and sponsor, that will prove to be a wining formula.

Disclaimer: I am not a tax advisor or CPA. This perspective is solely from years of experience managing mobile home park funds and working with the tax experts around us.

All the best,

Jack

[Kyle Winther]

The accelerated depreciation benefits can help offset the income you receive from the DST. There are a lot of factors to consider when investigating a DST. You should always heed the advice of your CPA for tax projections and depreciation befits for your current tax bracket and situation.

[Jack Martin]

One important item to note: if you receive passive losses from bonus depreciation and do not have a use (or only a partial use) for those passive losses in that calendar year, they can be used in subsequent years to offset gains as well. In other words, they don't expire if not used in the same calendar year they were derived. 

Also, if you never use all the benefit, whatever unused portion remaining is not subject to recapture when the property is sold in the future. 

All the best,

Jack

[David M.]

@Jack Martin

really?  "...whatever unused portion remaining is not subject to recapture..."

I believe once you take the depreciation, its depreciation subject to unrecapture.  If you have nothing to offset the depreciation, its carried forward as PAL --- one reason why 1031's are sometimes oversold in my opinion.

While one may consider the PAL and the depreciation unrecapture to offset each other, it doesn't always work that way.

[Jack Martin]

Yes, technically you are correct. It is carried forward as PAL, but if you don't use it over the life of the investment, it would be used to offset section 1250 recapture at the time of sale. Only the profit earned from the sale would be taxed as capital gains, which for most people is 20%. 

For those who use their PAL along the way to offset rental income (for example) they would benefit more since rental income is taxed as ordinary income. In that example, they would be exposed to section 1250 recapture at a flat rate of 25%. Assuming their marginal tax rate is higher than that, they gain tax arbitrage, plus the time value of money. 

[Zachary Jensen]

Quote from @Bill Brandt:

Bonus depreciation is simply pulling depreciation forward. That means owing more taxes in the future while decreasing the tax benefits of owning that property until you sell. So yes it will reduce the taxes owed this year but it will hurt every year in the future. It’s “probably” better than selling without a 1031 and buying without bonus depreciation, but way worse than just doing the 1031.  You’ll be under just as much pressure to buy something/anything to claim the bonus depreciation. 

 Exactly. I would do some research on "depreciation recapture" since that is important to consider over the lifetime of your time with the asset