Do I count depreciation tax shield in my cash flow analysis?

Question

Hello,

I've modeled my investment property cashflows in excel. In my model, should I be counting the depreciation tax shield as cash flow? Logically, it seems like it is cash flow since it is indeed, cash in my pocket. I plan to use the depreciation cash flow in other investments of stock or real estate.

Finally, if I move back into the rental property for 2 years, can I avoid depreciation recapture using the $250k tax exemption on sale of owner occupied homes?

Thanks

Jeff Wang · Answer

I am not sure that I agree that depreciation tax shield is creative math. I think of it more like a dividend paid from Uncle Sam. If I don't account for it in my cash flow analysis, how should I count it? It is definitely money that I can use to pay down the mortgage or for whatever else. If I do a 1031 exchange, I'll never have to repay the depreciation.

If I'm trying to calculate a return on investment, how do I account for the depreciation tax break?

Bill Exeter · Answer

@Ryan Logsdon is not correct regarding the $250,000 tax free exclusion. First, depreciation recapture can not be avoided through the 121 Exclusion. Second, Section 121 of the Internal Revenue Code was modified in 2008. Capital gain is now allocated between the number of years that you held the property as rental property (non-qualified use) versus the number of years that you lived in it as your primary residence (qualified use). The gain allocated to non-qualified use is taxable and the gain allocated to qualified use is tax free up to the $250,000 limit.

@Ryan M. Depreciation recapture is only taxed if you sell and do not structure a 1031 Exchange. Depreciation recapture is not taxed (does not have to be paid back) if you continue to 1031 Exchange throughout your lifetime and then your heirs inherit the property at your death (i.e. "swap 'til you drop).

David Beard · Answer

Jeff Wang - of course the tax shield is real money and should be included in your computations. As far as how to do it, you can simply compute an "after tax return" on your investment, and if you like you can compute a "pre-tax equivalent return", where you divide the A/T return by (1 minus your marginal tax rate). This is done all the time with investments that enjoy some sort of tax benefit/preference/credit.

The pre-tax equiv return can be more readily compared to other fully taxable yields you see out there in the marketplace.

As far as your cash flow scheduling, this should be done on an after-tax basis anyway, so you will pick it up in that analysis. After all, it's not now much you make, it's how much you keep...

Jeff Wang · Answer

That is a useful article but it doesn't talk about depreciation recapture. It did link to the IRS website and it appears you cannot avoid depreciation recapture using the personal gain exemption ($250k):

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Sale-of-Residence---Real-Estate-Tax-Tips

Steven Hamilton II · Answer

Short version: Never count on it. Think of it as an added bonus. Yes it does help; however, You need to remember recapture.

-Steven

Bill Exeter · Answer

You are most welcome!

Ryan Logsdon · Answer

It's a derivative, and as such, it's not a part of the basic cashflow equation.

That's not to say you can't add it in. Go for it. But you're no longer calculating your cashflow. You're calculating end-of-year finances.

Good catch Bill Exeter. Thanks for the correction.

Bill Exeter · Answer

@Ryan M sorry, my bad, you did say that. My apologies!

Ryan M. · Answer

And that's why I said 1031 is a way around it.

Jeff Wang · Answer

I should also mention, doing the standard discounted cash flow analysis on my investment property would take into account depreciation.

Do I count depreciation tax shield in my cash flow analysis?

Do I count depreciation tax shield in my cash flow analysis?

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