All Forum Posts by: Melanie Baldridge

Here is a framework to think about how buying properties creates the most tax efficiency for you.

The 6 levers of depreciation:

Lever 1 - % of Land

One of the components of a property is land.

Land is NOT DEDUCTIBLE, so low value land properties mean more tax deduction.

A value of your overall purchase will be assigned to the land or lot.

You receive no near-term tax benefits for buying land.

For example - If you buy a $2 MM industrial building outside a rural town on 5 acres, the land value could be $5k an acre. The land represents ~1% of the purchase

On the contrary - if you purchase a $2 MM shack in manhattan on a postage stamp lot, the land could represent 99%

Lever 2 - % of the property with a shorter useful life.

Not all parts of a piece of real estate are depreciated at the same speed.

Certain personal property assets have SHORTER lifespans in the eyes of the IRS vs the standard 27.5/39 year lives

Properties with tons of this often have:

- Over-developed land sites (hardscaping, pools, retaining walls)
- Fancy Fixtures
- Fancy Furniture (STRs!)
- Lots of Equipment (R&D Facilities, Car Washes)
- Gas Stations (100% 15 year properties)
- Movable walls (self storage)

You can find anywhere from 15-35% of the purchase price of a typical apartment complex is this type of property.

More of it means less tax for you from higher depreciation amounts!

Lever 3 - % of Leverage

This is a big one! The more leverage (debt) that is applied to a property or deal, the more cost savings you will get up front relative to the equity you put in.

Let's say you buy a $10 MM dollar deal that has $3 MM of year one depreciation.

If you used $7m of bank debt and only $3m of equity, your year 1 deduction will equal the amount of money you put into the deal!

If you had used cash for the full $10 m, you would get a deduction worth 30% of your investment.

(remember, more debt = more risk)

Lever 4 - % Tax Rate

Another HUGE consideration.

Depreciation is a deduction that you are allowed to take at your Marginal Tax Rate. Similar to a 401k, part of the strategy is a tax arbitrage.

It is a much better outcome to take the deduction at 37% rather than 24%.

Lever 5 - % Bonus Allowed

In 2023 Bonus depreciation has been limited to 80%, and will continue to ramp down 20%/yr until it hits zero in 2027.

Bonus depreciation has come and gone in the past, but the more you get, that first year payback is higher and higher.

Lever 6 - % Payback Ratio

Ultimately how much you save vs. how much you pay matters.

Caveat - Talk to your CPA before you purchase a cost seg study.

You need to have a way to monetize your losses through

1. Being a Real Estate Pro
2. Having Passive income you can offset
3. Using the STR (or carwash, etc..) Loophole

Don't cost seg if you can't use the losses!

You’re going to pay this entity more money than anyone else in your life.

If you're successful, that could mean that you will pay them millions over the course of your business career.

So who is “this entity?”

That's right. Good old Uncle Sam.

For most folks in the US, taxes are anywhere from 30-50% of their gross income every year.

To protect yourself, you should do 2 key things.

1. Study and learn how the tax code works and where you might be able to optimize and save.

2. Hire the very best people you can to advise you based on your exact situation and circumstances and then let them help you implement a solid tax strategy that makes sense for you.

Regardless of your position and role, this is without a doubt one of the highest leverage activities that you can do.

Remember, it's not just about what you make, it's about what you keep in the end that matters most.

Quote from @Marc Lock:

How is material participation defined?

Once a taxpayer meets the REP status, do they need to materially participate in each property?

No. You don’t have to materially participate in each property.

If you own multiple properties, you can elect to group them together as a single activity for tax purposes, known as a "grouping election.”

This allows you to meet the material participation requirements based on your combined activities across all the grouped properties.

But yes, RE Pros still have to spend over 750 hours in real estate activities during the year (and more time doing this than anything else) to be considered material.

Reminder:

Ground improvements qualify for bonus depreciation.

This includes various landscaping.

Roads and external parking areas.

Sidewalks and pathways.

Fences.

Utility systems (including the installation or improvements to water, sewage, drainage, and electrical systems).

Outdoor lighting.

Rec facilities (like playgrounds, sports courts, and swimming pools).

And more.

It's a big category for depreciation/bonus depreciation that we love.

What a lot of people think:

Bonus depreciation is only for new properties or acquisitions.

The truth:

You can retroactively apply bonus depreciation to property placed in service after September 27, 2017, when the Tax Cuts and Jobs Act passed changing various rules.

The IRS allows you to claim missed depreciation deductions by adjusting your current year's tax return, without needing to amend the previous year's returns.

This is typically done through a change in accounting method using IRS Form 3115.

Here are a few definitions that you absolutely must know.

Bookmark this thread and use it as your cheat sheet for 2024.

Okay, let’s dive in:

Here are the terms that I’ll define in this thread:

-DEPRECIATION

-BONUS DEPRECIATION

-COST SEGREGATION

-BASIS

-LAND VALUE

-IMPROVEMENT VALUE

-3115

-RECAPTURE

DEPRECIATION:

Depreciation is the decrease in $$ value of your asset over time due to wear & tear, etc.

Standard depreciation is deducted evenly over 27.5 years for residential and 39 years for commercial.

Even w/o cost segregation you get to deduct depreciation each year.

BONUS DEPRECIATION:

This is an accelerated depreciation method. It allows a substantial portion of the asset's cost to be deducted in the first year of service.

In 2023, the bonus depreciation rate is 80%.

In 2024, it decreases to 60%.

In 2025, the rate further reduces to 40%.

COST SEGREGATION:

Cost segregation involves dividing a property into its individual components for tax purposes.

Some parts age faster, like carpets or paint.

Your CPA can use this info to more accurately depreciate elements of your property leading to potential tax savings.

BASIS:

Your basis is the initial price that you paid for your property, including any expenses or improvements.

Knowing your basis is crucial for tax purposes, as it's used to evaluate depreciation & determine the capital gains or losses if/when your property sells.

LAND VALUE:

This is how much your land is worth without any buildings or improvements.

Land doesn't get old like buildings, so you can't depreciate it. But knowing its value is key for taxes.

IMPROVEMENT VALUE:

This is the value of all the upgrades you make to your property – like a new roof or an updated kitchen.

These improvements can be depreciated, which means tax savings for you.

3115:

Filing this form can allow you to claim missed depreciation from past years.

Basically you are letting the IRS know that you are moving from the standard deduction to an accelerated deduction.

RECAPTURE:

It's payback time! If you sell your property, you will likely have to pay back some of the taxes deferred from depreciation.

Think of cost seg as an interest free loan from Uncle Sam - it comes due when you sell the property.

My motto:

Don't let industry jargon stop you from making smart financial moves!

The playbook on how to use real estate to build wealth tax efficiently:

1. Buy with moderate leverage

2. Cost segregate and depreciate initial capital in

3. Stabilize and borrow tax free against your asset

4. Enjoy low tax cashflow year over year

5. Eventually 1031 exchange into a larger asset and repeat

6. Die and step up basis

7. Have your heirs repeat

Many wealthy families do this over and over again and pay little to no taxes as their RE portfolio continues to grow.

What happens to your RE portfolio when you pass away?

Do your heirs pay significant taxes?

This is a common question among real estate owners.

Let's dive in:

The reality is that wealthy families often pass on real estate assets from generation to generation.

For example, if one generation has an RE entrepreneur who amasses $50 million worth of real estate, that portfolio can generate enough cash flow to support multiple future generations comfortably when passed on.

So, what happens if that initial investor built their empire by rapidly depreciating assets and using 1031 exchanges to lower the basis and defer taxes along the way?

Do these tax advantages disappear when the original owner passes away and hands the portfolio to their children?

The answer is no, they do not!

The current tax code provides special benefits in this situation.

When the original owner passes away, the "basis" of the assets resets to the market value at the date of death.

In the US, there is currently an estate tax exemption of approximately $13 million per person, which allows the basis to reset, and depreciation can start anew.

This “step-up in basis” is particularly useful if the next generation wants to sell the asset.

Since their basis is set at market value, if the property is sold at that value either at the date of death or within six months, there is no capital gain and no taxable event.

There have been many examples where portfolios of fully depreciated real estate worth tens of millions of dollars have been passed down from one generation to the next, resulting in little to no tax liabilities for their heirs.

Pretty cool, right?

As always, tax laws in the US are subject to change so it's always best to consult with a tax pro or estate planner for the most current and personalized advice.

You’re going to pay this entity more money than anyone else in your life.

If you're successful, that could mean that you will pay them millions over the course of your business career.

So who is “this entity?”

That's right. Good old Uncle Sam.

For most folks in the US, taxes are anywhere from 30-50% of their gross income every year.

To protect yourself, you should do 2 key things.

1. Study and learn how the tax code works and where you might be able to optimize and save.

2. Hire the very best people you can to advise you based on your exact situation and circumstances and then let them help you implement a solid tax strategy that makes sense for you.

Regardless of your position and role, this is without a doubt one of the highest leverage activities that you can do.

Remember, it's not just about what you make, it's about what you keep in the end that matters most.

When thinking about depreciation it's not about when you buy the property, it is when you "put it into service."

When you buy determines your short/long term capital gains.

The "in-service" date = The point in time when you can start taking depreciation from.