This is a hypothetical situation. Billy has a day job earning $100,000 per year in California. He wants to build a real estate empire in his local market as the king of residential real estate (1-4 units). What value of real estate holdings would he need to have enough depreciation to offset $100,000 of gross income (assuming he does not buy commercial real estate)?
This would depend on the rent return etc...ignoring that for a second....
If he has 100K in W-2, and needs 100K in depreciation...then he needs 100K*27.5 years is 2.75 Million in improvements, or 3.925 (2.75M/70%) in asset value. Of course that increases by however much rental income is also being brought in and eating away at the depreciation already....
Obviously an over simplified response, but that's your answer.
@David Lao Understand for sure. 1031 is just one way to skin the recapture cat so to speak. Probably one of the more stressful and difficult as well, not to mention in the politicians spotlight at the moment. Many investors, on the year of recapture, will simply reinvest a portion into a new investment in same year as sale or exit of 1st investment, thus garnering depreciation again to offset gains and recapture. These are now long term gains, taxed differently, which also is beneficial. Everything of course always depends on your lifestyle and what matches your investment strategy.
I am by no means saying syndication is the only route for sure, just saying larger deals and being part of them typically yield good benefits in a variety of categories, depreciation being one of them. Smaller deals might have better returns if fully owner managed, but typically require more risk and more time.
However, I fully recommend having a call with tax strategist who can showcase the best option for your scenario(ensure they invest in real estate for best outcome).
If you are able to implement a real estate professional status tax strategy (REP) you can use passive losses from syndication deals to lower your ordinary W2 income. If not (ie two full-time working spouses) your only other option is going into land conservation deals, solar deals, or oil and gas deals - all of which have some risks.
Explained in a different way...
1) There are ordinary/W2/active income on one side. Lets call that the :( side.
2) And there is the happy side... passive income (syndications, passive partnerships ie medical/dentist offices) and passive losses (depreciation, bonus depreciation via cost segregations common in syndications). You can you passive losses to neutralize/eliminate passive income. Thats what this is the good side and why passive losses are called PALs too for passive activity losses.
So there is a barrier between 1) Active Income and 2) Passive Income above. You cannot offset passive losses (PALs) for active income. UNLESS you are are real estate professional status for tax designation purposes and able to create a "grouping/active participation".
So when a deal is successful and sold (full cycle) what happens then?
All investors will have to pay back the depreciation recapture (losses taken throughout the hold) and capital gain (the big payout on the end which is sale minus cost basis). But don't despair because although this is the case when you look at it myopically, in reality most investors go into multiple deals accumulating 100s of thousands of passive activity losses in their first few years investing. Those losses do not go away, but they become suspended to be used to offset future passive income and sales/capital events like this in the future. When you exit a deal, what normally ends up happening (like Tom Brady keep winning more Super Bowls) is that you go into two more deals (with now double the amount of capital) and you will likely find that with those new K1s you could result in you having way more passive losses you began with If you can see where this is going... yes, experienced investors with a lot of capital deployed might have 500k-1M+ suspended passive losses and have not paid taxes in years and do not appear to pay taxes for years! (you can find how much suspended passive losses you currently have on your IRS Form 8582 - which your CPA is likely not giving to you and in that case you should get a new one)
@Yonah Weiss when are you going to get my cost segs done :P
Once you get all the active and passive issue sorted out and assure that one spouse is a qualified real estate professional, I would look hard at mobile home park Syndications and funds. I was blown away when I saw the amount of depreciation you can get through a cost segregation study and particularly the bonus depreciation available for a few more years.
Feel free to PM me if you want to see the math on this. I can also recommend you to a few good mobile home park funds that I am best in myself. Good luck!
@David Lao you might be interested in episode 569 of the BP podcast. It gives some detail on active vs passive loss and what will actually qualify you as RE professional.
This is an impossible question. You could theoretically do it with one property if you have a short-term rental, materially participate (don't need to rise to being a real estate professional for this) and accelerate your depreciation for a singular year. If your rental income is zero before factoring in depreciation and you qualified as a real estate professional whatever number divided by 27.5 will reduce your income to zero. Which in this case for simplicity would be 2.75 million in building depreciation utilizing MACRS Straight line would give you the 100K depreciation per year.
If you are W-2 goodluck claiming real estate professional status - if audited people lose in tax court almost always
If you are able to implement a real estate professional status tax strategy (REP) you can use passive losses from syndication deals to lower your ordinary W2 income. If not (ie two full-time working spouses) your only other option is going into land conservation deals, solar deals, or oil and gas deals - all of which have some risks.
Explained in a different way...
1) There are ordinary/W2/active income on one side. Lets call that the :( side.
2) And there is the happy side... passive income (syndications, passive partnerships ie medical/dentist offices) and passive losses (depreciation, bonus depreciation via cost segregations common in syndications). You can you passive losses to neutralize/eliminate passive income. Thats what this is the good side and why passive losses are called PALs too for passive activity losses.
So there is a barrier between 1) Active Income and 2) Passive Income above. You cannot offset passive losses (PALs) for active income. UNLESS you are are real estate professional status for tax designation purposes and able to create a "grouping/active participation".
So when a deal is successful and sold (full cycle) what happens then?
All investors will have to pay back the depreciation recapture (losses taken throughout the hold) and capital gain (the big payout on the end which is sale minus cost basis). But don't despair because although this is the case when you look at it myopically, in reality most investors go into multiple deals accumulating 100s of thousands of passive activity losses in their first few years investing. Those losses do not go away, but they become suspended to be used to offset future passive income and sales/capital events like this in the future. When you exit a deal, what normally ends up happening (like Tom Brady keep winning more Super Bowls) is that you go into two more deals (with now double the amount of capital) and you will likely find that with those new K1s you could result in you having way more passive losses you began with If you can see where this is going... yes, experienced investors with a lot of capital deployed might have 500k-1M+ suspended passive losses and have not paid taxes in years and do not appear to pay taxes for years! (you can find how much suspended passive losses you currently have on your IRS Form 8582 - which your CPA is likely not giving to you and in that case you should get a new one)
@Yonah Weiss when are you going to get my cost segs done :P
What Lane mentioned here is IRS code (Sec. 469(g)(1)(A)): upon a taxable disposition of a passive activity, the taxpayer may use any remaining suspended passive activity gain allocated to that activity first against passive loss from the same activity, then against net passive loss from other passive activities, and then as a nonpassive income.
In practicality, segregation most likely benefits the GP side (LP not so much) and becoming RE Pro is almost nonpractical (except in Airbnb-self managed case); the PAL offset route is much easier to implement.
@Carlos Ptriawan @Kevin Chubet There is a misunderstanding of STR here in these posts. First, STR must be depreciated over 39 years, not 27.5. Second, You don't have to be a Real Estate Professional to make your STR an active investment, you simply have to materially participate in its management according to the IRS' terms. Active participation in a STR is a business and is treated much like a hotel. Having a W2 income and claiming RE Professional Status is a great trigger for an IRS audit. On the other hand, if a spouse actually meets the qualifications for being a RE professional (meticulous documentation) and you have W2 income, you may be in the clear.
@Carlos Ptriawan @Kevin Chubet There is a misunderstanding of STR here in these posts. First, STR must be depreciated over 39 years, not 27.5. Second, You don't have to be a Real Estate Professional to make your STR an active investment, you simply have to materially participate in its management according to the IRS' terms. Active participation in a STR is a business and is treated much like a hotel. Having a W2 income and claiming RE Professional Status is a great trigger for an IRS audit. On the other hand, if a spouse actually meets the qualifications for being a RE professional (meticulous documentation) and you have W2 income, you may be in the clear.
STR materially participate yes can offset
Long-Term rental without RE professional status will stay passive.
STR is 39 years, traditional 27.5 but you are in it for the bonus depreciation if you want to offset income. The building/components getting depreciated over the longer life won't have much impact
@Carlos Ptriawan @Kevin Chubet There is a misunderstanding of STR here in these posts. First, STR must be depreciated over 39 years, not 27.5. Second, You don't have to be a Real Estate Professional to make your STR an active investment, you simply have to materially participate in its management according to the IRS' terms. Active participation in a STR is a business and is treated much like a hotel. Having a W2 income and claiming RE Professional Status is a great trigger for an IRS audit. On the other hand, if a spouse actually meets the qualifications for being a RE professional (meticulous documentation) and you have W2 income, you may be in the clear.
STR materially participate yes can offset
Long-Term rental without RE professional status will stay passive.
STR is 39 years, traditional 27.5 but you are in it for the bonus depreciation if you want to offset income. The building/components getting depreciated over the longer life won't have much impact
Assuming it is an STR that you materially participate in then yes.
Now it comes down to what the improvements are and when the property is placed in service. If it is furnishing the property, land improvements, ect. then utilize 39 year. I usually function aggressively in the depreciation space because over 39 years with time value of money that deduction honestly is terrible
Assuming it is an STR that you materially participate in then yes.
Now it comes down to what the improvements are and when the property is placed in service. If it is furnishing the property, land improvements, ect. then utilize 39 year. I usually function aggressively in the depreciation space because over 39 years with time value of money that deduction honestly is terrible
Yes this would be an STR.
One other thing I'm confused about. As we transition into 80% bonus depreciation in 2023 (and 60% in 2024, 40% 2025 etc assuming no action by congress), what happens with the remaining 20% of that allowed expense that I cannot write off for 2023? Does that get divided over the remaining years of depreciation allowed for that type of expense?
Example: If I spend $10K in furnishings in 2023 and the depreciation cycle is 5 years, would I deduct $8K in 2023 then $5K/year for the next 4 years?
Big thanks! @Kevin Chubet
Let me clarify a question you had earlier. You may or may not be able to use the 100% bonus to depreciate that $50K in improvements. Here are some questions that will make a difference: 1. Did you make these improvements in the same year you bought the property? 2. Were these actually improvements or were they repairs? 3. Do you have itemized receipts for what was done? 4. Did you do these "improvements" yourself or did you contract those out?
If you do actual "improvements" to a property in the first year of ownership, they must be added to your basis in the property. If they are repairs, they can usually be expensed. Part of the "material participation" requirement is that you must provide more service time than anyone else...that means if your cleaning crew does more time on the property than you do, you are not "materially participating" according to the IRS.
If the "improvements" were done after you have owned the property for one tax filing year, some may be able to be expensed or depreciated up-front and others may have to be depreciated over 27.5 or 39 years. This would require that we take a closer look at what you and your CPA/tax professional are calling "improvements".
This gets complicated and is exactly why professionals need to be involved. This is a specialty area of tax laws. The last thing any investor wants is to be contacted by the IRS. If I can be of additional assistance, let me know.
Assuming it is an STR that you materially participate in then yes.
Now it comes down to what the improvements are and when the property is placed in service. If it is furnishing the property, land improvements, ect. then utilize 39 year. I usually function aggressively in the depreciation space because over 39 years with time value of money that deduction honestly is terrible
Yes this would be an STR.
One other thing I'm confused about. As we transition into 80% bonus depreciation in 2023 (and 60% in 2024, 40% 2025 etc assuming no action by congress), what happens with the remaining 20% of that allowed expense that I cannot write off for 2023? Does that get divided over the remaining years of depreciation allowed for that type of expense?
Example: If I spend $10K in furnishings in 2023 and the depreciation cycle is 5 years, would I deduct $8K in 2023 then $5K/year for the next 4 years?
Big thanks! @Kevin Chubet
Assuming it is an STR that you materially participate in then yes.
Now it comes down to what the improvements are and when the property is placed in service. If it is furnishing the property, land improvements, ect. then utilize 39 year. I usually function aggressively in the depreciation space because over 39 years with time value of money that deduction honestly is terrible
Yes this would be an STR.
One other thing I'm confused about. As we transition into 80% bonus depreciation in 2023 (and 60% in 2024, 40% 2025 etc assuming no action by congress), what happens with the remaining 20% of that allowed expense that I cannot write off for 2023? Does that get divided over the remaining years of depreciation allowed for that type of expense?
Example: If I spend $10K in furnishings in 2023 and the depreciation cycle is 5 years, would I deduct $8K in 2023 then $5K/year for the next 4 years?
Big thanks! @Kevin Chubet
Thank you @Bonnie Griffin Kaake ! That is exactly what I was hoping to get answered. To answer your questions from the previous posts:
1) Yes, same year for improvements as purchase (2022)
2) Improvements- floors, drywall (demo'd the old wood paneling), open floor plan, new doors, new paint inside & out, etc
3) Yes
4) Yes, contracted
FYI I will seek professional advice so I am certainly not holding anyone to this.
@Jon Martin Your answers above tell me you must add these improvements to your basis. Then, with a cost segregation study, you will be able to expedite the depreciation with 100% bonus on anything that we can segregate (5, 7 & 15 years) up front for 2022. Let me know if you need an estimate.