Can I use 100% Bonus Depreciation as alternative to 1031 Exchange

15 Replies

Need some help with tax math here.    Wondering if this is a viable alternate strategy to a 1031 exchange?    Here are the specifics:

I'm getting ready to sell a rental property (Property A) for about $6.5M next month (June 2018).   My basis in it is around $2.8M.    Between recapture of previous depreciation, capital gains, and other taxes, I'm estimating my tax bill to be around $1M.   My primary goal would be to try to find a suitable 1031 replacement within the guidelines, however, I had another thought...

I happen to have gotten extremely lucky and purchased a $9.5M property (Property B) in Oct of 2017, and my cost segregation study was just completed and identified $2.4M of 5 and 15 year property that can qualify as bonus depreciation on last years tax return (which I have not yet filed).    This should cause just about all of that $2.4M loss to roll to 2018 as a passive activity loss carryover.

Here is my question:   Let's pretend I cannot execute the 1031 exchange for whatever reason.   Can I just buy (and close) any new rental property (Property C) in calendar year 2018, use a new cost segregation study to take advantage of bonus depreciation rules, and if this new property is of sufficient cost, use this bonus depreciation plus the carryover to completely wash out the gain of the sale of Property A?   I sure seems like this would work and I don't see any downside.     It seems like I'm just reducing my cost basis in Property A or C to offset the gain from the sale of B.

But the math is tricky in several ways.   First, I need to make sure Property C is large enough to generate enough bonus depreciation to finish washing out the gain.   If I use 20% as the amount of 5 and 15 year property in an apartment building, and I need another $1.5M of depreciation, it would suggest I need to buy something around $7.5M or so.    Correct?

Second, I'm reducing future depreciation on Properties A and C in favor of eliminating taxes today.   That's similar to 1031 concepts (defer tax to future years).    But I'll be increasing future income on properties A and C slightly due to less depreciation.   My thoughts are that even if income went slightly positive (instead of negative), overall it would keep me in lower tax brackets and probably eliminate the Obama tax that would kick in due to the outright sale of B with no 1031.   Do I have that right?

Third, I still have the options in the future to execute a 1031 exchange on property A or C, further deferring gains.

So could this be a viable alternative to a regular 1031 exchange?   Thanks everyone for your thoughts.

@Greg Ford ,  Well thought out.  You're right it's not the best of all worlds.  The real benefit of depreciation is to help you get to critical mass income point when you're a 1031 investor.  After that point it then lies dormant inside the property and waits your passing and the step up in basis.  

However, if you later want to re-energize the benefit of depreciation its as simple as performing a 1031 and purchasing more than your basis + gain in the old property.  That gives you a new clock and bank of depreciation.  Same thing could be applied to your scenario above should you choose to go that route.

Other options in between that could salvage that 1031 and are cropping up in the market place now -

1. There are some NNN properties out there now where things are in a flux and cap rates haven't compressed quite as quickly in time with the rest of the market.

2. There are some fractionals out there with shorter (1-2 year) holds that could accommodate a 1031 and again haven't compressed rate to awfully low.

3. A portfolio purchase might be another exploration.  More and more of these are cropping up.  A substantial enough portfolio could be managed in your scenario.  And at that point you've always got the option to later one off sales (paying tax as you go but controlling it) or add to depreciation in a more controlled environment within controlled 1031s inside the portfolio.  This would be a more effort intensive labor of love but if you like hands on would give you plenty of pieces to play with.

This is a lot better question than how to charge a late fee or what holiday gift to get for a resident.

Well thought out plan and this illustrates one of the huge benefits of commercial real estate, even at lower prices than discussed here.

I am not qualified to answer but your 20% appears rightfully conservative and your $7.5 million appears correct.

We all come here for answers and I typically don't like the "see your CPA" replies but there are tentacles into the rest of your tax return that may need to be factored in if you don't offset or defer the gain and recapture (phase outs, AMT, etc.).

Not part of your post, but another good use of cost segregation plus bonus depreciation plus real estate professional status is the possibility of performing a tax free Roth conversion...just brilliant...tax free in, tax free out.

Hi @Greg Ford , there is a better alternative to 1031 exchange.  I just sold a highly appreciated rental property in the Bay Area last year using a "Monetized Installment Sale". This deal structure let me get cash at closing and defer the capital gains and depreciation recapture for 30 years.

@Greg Ford , first and foremost, congratulations on your sale.

For the transactions that you have listed, you should have someone run models for the various scenarios so you can see what the after-tax cash flow is in each case including the net present value. 

In regard to the tax questions, just to give you an example of how things can get complicated very quickly (and therefore it is advisable to speak with your CPA/attorney), you mention that you purchased the property in October 2017 and you were projecting to use the 2.4m of bonus depreciation based on the cost seg. report. I am assuming you are calculating bonus using the new 100% rate. (Correct me if I'm wrong) Under the tax reform changes, the property must be both acquired and placed in service after September 27, 2017. The definition of these terms is important to look at closely. 

The acquisition date is not necessarily the closing date. The date of a written binding contract (as defined in the regulations) is also considered which may cause the new bonus to not apply and rather cause the old 50% to apply. You did not mention when you went into contract and you may have already considered this, but I wanted to make the quick note.

Not directly related to this scenario (Though I agree it's a little of robbing peter to pay Paul) - There is some interesting technique here. I suggested a similar strategy to a client today with regard to a MHP. We have some creative new options with bonus being allowed at 100% and on used now. 

But here is a note related to the new Bonus depreciation rules 

"The cost of the used qualified property eligible for bonus depreciation doesn’t include any carryover basis of the property, for example in a like-kind exchange or involuntary conversion." 

So if in the future you continue to utilize a similar strategy- you may face limitations on bonus depreciation allowed if the new property was acquired via 1031. 

Also, just another alternative in the event you can't complete the 1031, look into a DST. It's a passive real estate investment and the only one the IRS views as like kind. It is often a short term hold so it could juts be a place to park funds for a few years until the market hopefully cools down. 

Originally posted by @Senthil Akasham :

Hi @Greg Ford , there is a better alternative to 1031 exchange.  I just sold a highly appreciated rental property in the Bay Area last year using a "Monetized Installment Sale". This deal structure let me get cash at closing and defer the capital gains and depreciation recapture for 30 years.

I don't know if I'd call it better- just different. 

Additionally- the IRS while allowing this currently- isn't a huge fan of it. Just walk carefully with this method as it is being closely reviewed. 

Originally posted by @Senthil Akasham :

Hi @Greg Ford, there is a better alternative to 1031 exchange.  I just sold a highly appreciated rental property in the Bay Area last year using a "Monetized Installment Sale". This deal structure let me get cash at closing and defer the capital gains and depreciation recapture for 30 years.

 I've looked into these and had a conference call with someone to explain it to me.    As I recall, I only get 97% of the proceeds, this whole deal is tied up for the next 30 years with payments flowing into and out of a bank account I'd need to setup (the payments would wash each month though), and I remember thinking it was really expensive to do this.    It did seem like it could work, and could be an alternative, but I'm not sure I'd call it better than a 1031 exchange based on my research.

Originally posted by @Michael Torhan :

@Greg Ford , first and foremost, congratulations on your sale.

Under the tax reform changes, the property must be both acquired and placed in service after September 27, 2017. The definition of these terms is important to look at closely. 

 Good points, but the property purchased was an operating apartment building (built 30 years ago).    It closed in October 2017 and was operating on day one.   My CPA looked at it and said it qualified. 

Originally posted by @Natalie Kolodij :

"The cost of the used qualified property eligible for bonus depreciation doesn’t include any carryover basis of the property, for example in a like-kind exchange or involuntary conversion." 

So if in the future you continue to utilize a similar strategy- you may face limitations on bonus depreciation allowed if the new property was acquired via 1031. 

Also, just another alternative in the event you can't complete the 1031, look into a DST. It's a passive real estate investment and the only one the IRS views as like kind. It is often a short term hold so it could juts be a place to park funds for a few years until the market hopefully cools down. 

The property I bought last year did not have a 1031 exchange associated with it -- it was an outright purchase, so I believe you are saying that the full amount should qualify for bonus depreciation.    Property A I am selling did have a 1031 into it when I purchased it years ago, so I definitely want to try to keep the 1031 ball rolling with the purchase of property C.    However, I think you are basically saying that a new cost segregation on Property C after purchase would have to be ratio'd down somehow (ratio of my basis to the purchase price minus land?) before it could be applied to bonus depreciation?   That makes sense, though I would have to have my tax person figure that math out.   But conceptually it makes sense.

And in the future, if I were use bonus depreciation now, and want to 1031 property B or C into something new, the same thing would happen -- I wouldn't be able to claim the full amount of the cost segregation identified 5 and 15 year property on the replacement properties because of the lower basis.   

Am I hearing what you are saying?    This is good insight.    I appreciate it. 

Originally posted by @Greg Ford :
Originally posted by @Senthil Akasham:

Hi @Greg Ford, there is a better alternative to 1031 exchange.  I just sold a highly appreciated rental property in the Bay Area last year using a "Monetized Installment Sale". This deal structure let me get cash at closing and defer the capital gains and depreciation recapture for 30 years.

 I've looked into these and had a conference call with someone to explain it to me.    As I recall, I only get 97% of the proceeds, this whole deal is tied up for the next 30 years with payments flowing into and out of a bank account I'd need to setup (the payments would wash each month though), and I remember thinking it was really expensive to do this.    It did seem like it could work, and could be an alternative, but I'm not sure I'd call it better than a 1031 exchange based on my research.

I've actually modeled this scenario. I'm sure the guys that do 1031 Exchanges would argue with me, but I think the Monetized Installment Sale (MIS) is a superior way of disposing of a highly appreciated asset.

1. Both strategies allow you to defer the taxes. In a 1031 exchange, the taxes can theoretically be deferred until you die and then your heirs get the property with a step up in basis. That doesn't help your estate if there are taxes due though. The MIS allows you to get cash at closing and defer the taxes for 30 years.

2. 1031 exchange imposes a tight deadline. You have 45 days to identify your next investment property and 180 days to close. We are in a very hot real estate market with a lot of competition for properties to make exchanges. Research shows that the prices paid for 1031 exchange properties are about 19% higher than the market. In a MIS transaction you have cash in your hands. You can take your time to find a deal that makes sense. You can sit out the hot market and wait until the time is right to buy.

3. In a 1031 exchange your cost basis and depreciation are carried forward into the new property. This reduces the depreciation you are able to take on the new investment. In a MIS transaction you can purchase the new property with the cash from your monetization loan (and lender financing). You will start off with an all new cost basis and a fresh depreciation schedule. This means more income in your pocket right now. Every case is different, but the present value of the new depreciation will likely offset the tax benefit of infinite tax deferral versus 30-year tax deferral.

If inflation is running at 2.5%, the real cost of the future tax obligation 30 years out is about 50% of what it is today. Taking the depreciation on a new property will likely make up the difference. Additionally, you are essentially holding onto the government's money for 30 years before you have to pay them. Take the Rule of 72: if you could earn 7% on that money, you could double it 3 times over. So now you have 8X what you need to pay the taxes, that in real dollars, are only half of what they are today. You get to keep 7/8ths of it. That more than makes up for the small haircut you take on the monetization loan.

Originally posted by @Thomas Rutkowski :

I've actually modeled this scenario. I'm sure the guys that do 1031 Exchanges would argue with me, but I think the Monetized Installment Sale (MIS) is a superior way of disposing of a highly appreciated asset.

Lets go down this rabbit hole for a minute and talk more generally about how Monetized Installment Sales work -- help me understand:

1)   Let's pretend at closing that sales proceeds are $1M (ignore taxes and whatnot for now).    I would not receive this $1M -- it'd have to go to a Qualified Intermediary, right?

2)   Assuming #1 is true, it seems the QI arranges a loan using the $1M proceeds as collateral, and the loan proceeds are given to me correct?     I'm sure the terms of that loan vary, but I've heard you get between 95-97% of the amount ($970K in this case).   Is that typical?   Can you get 100%?   And the term is a 30 year loan usually?

3)   So now that a loan is involved, we need to pay interest.    As I understood the way it works, the interest on the new loan is covered by a payment made by the QI to me in the same amount (for holding the proceeds of the sale).    It's not clear to me how certain the payment from the QI to me is -- is it guaranteed in any way?   Could the QI default and I have no recourse?    How can the QI guarantee me a series of payments with interest?  

This whole step #3 is where I see the hornet's nest.   Perhaps it's not as complicated as I make it seem.  But it seems I need to setup a bank account which will receive the QI payment, and then pay the loan payment.   These two payments should wash each month.   And from a tax perspective, the QI payment includes a portion of my gain from the sale, but the loan payment (the interest portion), is a business expense (assuming I use the loan proceeds for a new investment) which should wash the gain out.

So what are the risks here?  The big one I think is the QI continuing to make a monthly payment to me for the next 30 years.    I also wonder what happens in 30 years when the new note gets paid off and the QI still has the sale proceeds (or has that all been paid out to me over those same 30 years)?

   

Originally posted by @Greg Ford :
Originally posted by @Thomas Rutkowski:

I've actually modeled this scenario. I'm sure the guys that do 1031 Exchanges would argue with me, but I think the Monetized Installment Sale (MIS) is a superior way of disposing of a highly appreciated asset.

Lets go down this rabbit hole for a minute and talk more generally about how Monetized Installment Sales work -- help me understand:

1)   Let's pretend at closing that sales proceeds are $1M (ignore taxes and whatnot for now).    I would not receive this $1M -- it'd have to go to a Qualified Intermediary, right?

First off, you can learn more here www.scrowcollateral.com. There are two parts to a Monetized Installment Sale transaction. Part 1 is the installment Sale through an intermediary. Its really no different from a 1031. Instead of a 180 day deferred payment, it is a 30-year interest only note. The Intermediary holds the funds and is subject to the terms of the purchase agreement between seller and intermediary. Part 2 is the Monetization. 

2)   Assuming #1 is true, it seems the QI arranges a loan using the $1M proceeds as collateral, and the loan proceeds are given to me correct?     I'm sure the terms of that loan vary, but I've heard you get between 95-97% of the amount ($970K in this case).   Is that typical?   Can you get 100%?   And the term is a 30 year loan usually?

Your note is not collateral for the monetization loan. That would likely make the loan proceeds taxable. It is an Income-based loan. There are several very important covenants in the loan agreement. 1. the sole source of recourse is the income coming from the installment sale. This eliminates personal liability if the intermediary were to default. This is absolutely necessary since you have essentially sold the property with nothing down and interest-only. 2. The lender is prohibited from writing off the loan. This would generate a 1099-C for the seller.  3. Lender will not report a default to credit agencies.

The monetization loan will be for an amount equal to 95% of the net sales proceeds. This will be further reduced by fees and points. You should expect about ~93.5%. 

If you can find a lender willing to finance 100% of anything, please let me know!!

3)   So now that a loan is involved, we need to pay interest.    As I understood the way it works, the interest on the new loan is covered by a payment made by the QI to me in the same amount (for holding the proceeds of the sale).    It's not clear to me how certain the payment from the QI to me is -- is it guaranteed in any way?   Could the QI default and I have no recourse?   

Addressed above.

How can the QI guarantee me a series of payments with interest?  

The loan is interest only. A default impacts the lender. The lender has no recourse against you personally.

This whole step #3 is where I see the hornet's nest.   Perhaps it's not as complicated as I make it seem.  But it seems I need to setup a bank account which will receive the QI payment, and then pay the loan payment.

A long term escrow account is set up at closing. The monthly payments from the intermediary go into this account. The money is transferred to another escrow account where it is transferred to the lender to make the payment on the loan. All of this happens automatically every month . The only thing you need to worry about is the 1099 you'll receive for interest income. The monetization loan is a commercial loan, so as long as the proceeds are used for business purpose, this should be an expense that offsets the income.

  These two payments should wash each month.   And from a tax perspective, the QI payment includes a portion of my gain from the sale, 

No. The contract is interest-only. There is nothing to worry about until the last and final balloon payment is received. That is when you'll have constructive receipt and that is when the taxes will be due.

but the loan payment (the interest portion), is a business expense (assuming I use the loan proceeds for a new investment) which should wash the gain out.

So what are the risks here?  The big one I think is the QI continuing to make a monthly payment to me for the next 30 years.    I also wonder what happens in 30 years when the new note gets paid off and the QI still has the sale proceeds (or has that all been paid out to me over those same 30 years)?

Take a look at this: http://investor.officedepot.com/phoenix.zhtml?c=94...

Its the largest known Monetized Installment Sale at $1.4 billion. If you read through carefully, you'll notice that the intermediary (Lehman) DID default on the loan after the 2007 economic crisis. As a result, Office Depot will NEVER PAY ANY CAPITAL GAINS TAX, EVER.