Strategy at End of 27.5 Year Depreciation

Tax, SDIRAs & Cost Segregation
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Strategy at End of 27.5 Year Depreciation

Ben Sears
Flipper/Rehabber · Farmville, VA · Member since 2018 · 280 posts · 171 votes

I was having a conversation with a partner on some of his SFR properties in regard to depreciation strategy. He owns three SFR with a monthly cash flow of ~$2600. Two of the properties are paid off and one has a mortgage. All are nearing the end of the 27.5 year depreciation cycle. So BP, I ask the experts what are your strategies with regard to taxes and depreciation? Does he sell the properties and 1031 into something with more cash flow and depreciation deduction or keep the properties and maintain his cash flow? What are the pros and cons to both?

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
7y

@Anthony Clayton, unfortunately you do not get a new depreciation clock simply by doing a 1031 exchange.  As @Christopher Smith said, in a 1031 your basis is carried forward into the new property.  So if you only buy as much as you sell you will not get any more depreciation to claim.  But you will defer all of the depreciation recapture along with the tax on gain.

If you want to get access to more depreciation then one of the answers for @Ben Sears friend would be to purchase more than you sell.  The additional amount becomes additional depreciable basis.  So if you have a property that you depreciated down to 0 and sell it for $100K  using a 1031 exchange to purchase a $200K property you're in essence getting a fresh $100K ish of depreciation to claim.  But you don't get to re-depreciate the original $100K.

Ben,  Most investors will follow one of the following paths.  @Steven Ko is spot on - It just depends on where the investor is in their life cycle and what the numbers look like.

1. If the properties are providing a good roi and investor has energy or good management in place then keeping them is certainly an option.  No debt and no depreciation available makes it much like an annuity.  So price and compare the return accordingly.

2. If growth is desired, the investor has energy, doesn't mind debt and needs tax breaks then a 1031 into larger properties allows for geometric growth and new depreciable basis.  The debt service is also an expense paid for by the tenants.

3. If investor is tired and done with active management or can't find good passive management or doesn't like the emotional stress then once again a 1031 in in order to defer all depreciation and tax on gain. But the 1031 would be into a passive vehicle designed to be out of sight out of mind and simply produce cash flow. Like a NNN commercial or if those numbers are too large then a fractional DST or TIC. Fully 1031 compliant but also passive. So just like scenario 1 they act like an annuity.

In all three cases the key is that you avoid the significant tax on depreciation recapture and gain and get to continue using that deferred money to generate returns for you personally until death when it does reset for your heirs and they get the property tax free.

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  • Christopher Smith
    Investor · brentwood, CA · Member since 2016 · 1k+ posts · 730 votes
    7y

    In a 1031 don't you carry-over the exchanged property's depreciation balances into the new property (to the extent of the 1031 money)?

    1Reply
  • Anthony Clayton
    Investor · Rancho Cucamonga, CA · Member since 2011 · 14 posts · 8 votes
    7y

    I would move up to buy a larger multi-family building using 1031.

    1Reply
  • Anthony Clayton
    Investor · Rancho Cucamonga, CA · Member since 2011 · 14 posts · 8 votes
    7y
    Originally posted by @Christopher Smith:

    In a 1031 don't you carry-over the exchanged property's depreciation balances into the new property (to the extent of the 1031 money)?

    No the depreciation do not carry over. It start over when you buy a new property.

    1Reply
  • Steven Ko
    Sunnyvale, CA · Member since 2018 · 191 posts · 178 votes
    7y

    @Ben Sears this is just my opinion. I only own one property. My partner and I have talked about this before. I’m a do nothing kind of guy. Stocks? Haven’t sold a single stock in our joint portfolio. I don’t have any exit plans for real estate. But I do plan to grow my portfolio where I can start living a lot more comfortably. It seems like your friend likes to take it slow and simple? 3 houses in 20+ years. If things are working out from him and he doesn’t want to add any more work, he should keep his properties. I’m sure many will say, follow the cash flow, drink the kool aid. But there are many factors to consider. He’s survived multiple crashes (my guess is many BP members haven’t experienced one, myself included).

    I think a discussion with a fee only financial advisor with give much better advice because they can look into his expenses, how close he is to retirement, and plan for his future goals.

    You gotta remember who you’re asking for advice and asking a bunch of people who want to grow their portfolio, will simply tell you to grow the portfolio.

    3Reply
  • Christopher Smith
    Investor · brentwood, CA · Member since 2016 · 1k+ posts · 730 votes
    7y
    Originally posted by @Anthony Clayton:
    Originally posted by @Christopher Smith:

    In a 1031 don't you carry-over the exchanged property's depreciation balances into the new property (to the extent of the 1031 money)?

    No the depreciation do not carry over. It start over when you buy a new property.

    For tax purposes (i.e., for IRC 1031 purposes), it's not treated as the purchase of a new property. It's treated as a tax deferred exchange, which requires carry-over of the tax basis related calculations from the relinquished property (at least to the extent of the 1031 money - i.e., the money from the relinquished property's disposition).

    1Reply
  • Alan Grobmeier
    Rental Property Investor · Phoenix, AZ · Member since 2013 · 919 posts · 911 votes
    7y

    The guy needs a 'dedication'. How about taking a 50% LTV loan on all properties AND then investing the money in other properties or elsewhere?

    Paid off properties are just what the IRS wants.  No depreciation is even better.  ;-)

    2Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    7y

    @Anthony Clayton, unfortunately you do not get a new depreciation clock simply by doing a 1031 exchange.  As @Christopher Smith said, in a 1031 your basis is carried forward into the new property.  So if you only buy as much as you sell you will not get any more depreciation to claim.  But you will defer all of the depreciation recapture along with the tax on gain.

    If you want to get access to more depreciation then one of the answers for @Ben Sears friend would be to purchase more than you sell.  The additional amount becomes additional depreciable basis.  So if you have a property that you depreciated down to 0 and sell it for $100K  using a 1031 exchange to purchase a $200K property you're in essence getting a fresh $100K ish of depreciation to claim.  But you don't get to re-depreciate the original $100K.

    Ben,  Most investors will follow one of the following paths.  @Steven Ko is spot on - It just depends on where the investor is in their life cycle and what the numbers look like.

    1. If the properties are providing a good roi and investor has energy or good management in place then keeping them is certainly an option.  No debt and no depreciation available makes it much like an annuity.  So price and compare the return accordingly.

    2. If growth is desired, the investor has energy, doesn't mind debt and needs tax breaks then a 1031 into larger properties allows for geometric growth and new depreciable basis.  The debt service is also an expense paid for by the tenants.

    3. If investor is tired and done with active management or can't find good passive management or doesn't like the emotional stress then once again a 1031 in in order to defer all depreciation and tax on gain. But the 1031 would be into a passive vehicle designed to be out of sight out of mind and simply produce cash flow. Like a NNN commercial or if those numbers are too large then a fractional DST or TIC. Fully 1031 compliant but also passive. So just like scenario 1 they act like an annuity.

    In all three cases the key is that you avoid the significant tax on depreciation recapture and gain and get to continue using that deferred money to generate returns for you personally until death when it does reset for your heirs and they get the property tax free.

    The 1031 Investor5140 Reviews
    WebsiteView Page
    11Reply
  • Michael PlaksPro Member
    Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
    7y

    @Ben Sears

    If I understand your and your partner's thinking - you're considering selling or exchanging properties simply because you will no longer have depreciation. If so, then I struggle to relate to your thinking.

    The two pillars of investing are cash flow and appreciation. Neither one is affected by depreciation! In other words, the fundamentals of your investment stay the same. You simply start paying a little more taxes on your cash flow. Of course it matters, and you can argue that it does reduce the net cash flow, but it cannot be considered a trigger for selling or exchanging!

    The trigger to sell is when your properties no longer provide optimal cash flow or appreciation - or when your goals or financial/personal situation change. Something should change with the properties or with you, not with your taxes.

    While it may be time to re-evaluate your portfolio and consider if you might do better with other investments, you're giving your taxes way too much importance in this process. Letting the tail wag the dog.

    6Reply
  • Ben Sears
    OP
    Flipper/Rehabber · Farmville, VA · Member since 2018 · 280 posts · 171 votes
    7y

    Thanks @Dave Foster this was exactly what I was looking for. Can you elaborate more on "fractional DST or TIC". I didn't follow you on that.

    @Michael Plaks I wasn’t treating this as a trigger so much as a possible time to re-evaluate the portfolio. If the best strategy is to maintain the properties, take the cash flow and zero debt then so be it. 

    3Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    7y

    DSTs (Delaware Statutory Trusts) and TICs (Tenants in Common) are specific products that have been blessed by the IRS to be 1031 compliant. Which means you can sell your real estate and purchase a DST or TIC as your replacement property and defer all tax and depreciation recapture. just as with any other property.

    They are fractional meaning you are purchasing a % of a larger asset so it is an affordable entree for many t get into passive NNN commercial investing without the large ticket of buying a 100% of a project.

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    1Reply
  • Ben Sears
    OP
    Flipper/Rehabber · Farmville, VA · Member since 2018 · 280 posts · 171 votes
    7y

    @Dave Foster thanks for that. Learn something every day. 

    0Reply
  • Randy Bloch
    Rental Property Investor · Minneapolis · Member since 2019 · 257 posts · 244 votes
    7y

    @Dave Foster

    I have been thinking about 1031 into DST or TIC as part of my exit strategy. I sent DM to connect, would like to ask u a question offline.

    1Reply
  • Natalie Schanne
    Real Estate Agent · Princeton, NJ · Member since 2016 · 1k+ posts · 1k+ votes
    7y

    @Ben Sears - remember his heirs get free stepped up basis on death, so holding until death is a decent strategy for minimizing taxes. To maximize ROI, it's good to refinance the homes and pull 75-80% of the money out and buy other properties, invest in a syndication/multi family, make private money loans (at higher than your mortgage rate), etc.

    4Reply
  • Account Closed
    Rental Property Investor · Brooke Park Drive · Member since 2018 · 1k+ posts · 2k+ votes
    7y

    Try the 4 D’s strategy:

    defer, defer, defer, and die 

    3Reply
  • Account Closed
    Rental Property Investor · Brooke Park Drive · Member since 2018 · 1k+ posts · 2k+ votes
    7y

    Ps u could move into each house for two years to make it a primary residence to get huge tax benefits

    0Reply
  • Randy Bloch
    Rental Property Investor · Minneapolis · Member since 2019 · 257 posts · 244 votes
    7y

    @Michael P.

    Suggest u research this more. The tax laws have changed and this loophole has been closed.

    2Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · Sarasota, FL · Member since 2017 · 5k+ posts · 3k+ votes
    7y
    Originally posted by @Anthony Clayton:
    Originally posted by @Christopher Smith:

    In a 1031 don't you carry-over the exchanged property's depreciation balances into the new property (to the extent of the 1031 money)?

    No the depreciation do not carry over. It start over when you buy a new property.

     Anthony, hopefully, you have restarted your depreciation. If this was true, everyone would be doing 1031. The depreciation does not start over. You only defer the recognition of unrecaptured 1250 gain with other cap gains. 

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    0Reply
  • Sam Shueh
    Real Estate Agent · Cupertino, CA · Member since 2016 · 4k+ posts · 1k+ votes
    7y

    Recapture the depreciation at sale. 

    sold price-dep recap-closing cost etc= X    Purchase another like property >X start another one with 1031 tax deferred exchange.

    0Reply
  • Syed H.
    Developer · NY/NJ/PA · Member since 2018 · 758 posts · 935 votes
    7y
    Originally posted by @Sam Shueh:

    Recapture the depreciation at sale. 

    sold price-dep recap-closing cost etc= X    Purchase another like property >X start another one with 1031 tax deferred exchange.

     Huh...? If you sell and 1031 you don’t pay dep recap. 

    2Reply
  • Sam Shueh
    Real Estate Agent · Cupertino, CA · Member since 2016 · 4k+ posts · 1k+ votes
    7y
    0Reply
  • Steve Vaughan
    Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes
    7y

    I've considered offering seller financing to exit.

    Will still have to recapture depreciation year 1 (ouch) but will stretch out the cap gain and provide years of cashflow.  

    1Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    7y

    @Syed H. you're right.  If you do a full 1031 (purchasing as much as you sell) you defer both depreciation recapture and tax on gain.  If you purchase more than what you sell then the additional amount you purchase is additional depreciable basis and you get to start depreciation on that amount. as well.

    @Account Closed, In 2008 the IRS tightened this up.  But it's still a good play.  Kudos for thinking of it.  Now if you convert a 1031 property into your primary residence there are some additional rules.

    1. You must have owned the property for at least 5 years before you can take the primary residence exclusion.

    2. You must have lived in it for 2 out of the 5 years prior to sale.

    3. When you sell you have to prorate the gain between periods of qualified use (as your primary residence and non-qualified use (as investment).  So you only get a percentage of the gain tax free.

    4. You still have to recapture depreciation.

    So if it is a property that is not heavily depreciated and you convert and live in for a few years it is possible to still get the lions share of the gain tax free.

    The 1031 Investor5140 Reviews
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    4Reply
  • Randy Bloch
    Rental Property Investor · Minneapolis · Member since 2019 · 257 posts · 244 votes
    7y

    @Dave Foster

    Thanks Dave! I knew the rules were tighter, but couldn’t recall the details.

    0Reply
  • Syed H.
    Developer · NY/NJ/PA · Member since 2018 · 758 posts · 935 votes
    7y
    Originally posted by @Sam Shueh:

     You should reread that link.

    0Reply
  • Michael PlaksPro Member
    Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
    7y
    Originally posted by @Account Closed:

    Ps u could move into each house for two years to make it a primary residence to get huge tax benefits

    As @Randy Bloch and @Dave Foster  already pointed out, you're incorrect. This strategy does not work anymore. 

    0Reply
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