Whether you are an active or passive investor, I am most positive you have surely heard “cost segregation” and “bonus depreciation.” One of the advantages of investing in real estate is that you are allowed to depreciate or “cost recover” the money you spend on the asset. The purpose of depreciation is to allow individuals and businesses who use property in productive use or in a trade to recoup their capital over the useful life of the asset against ordinary income as an expense so that capital can be reinvested to generate more money.
Upon acquisition, each asset is classified into a specific class life based on the general rules set forth in the Internal Revenue Code. Once the class life is determined, a statutorily defined deduction is taken for depreciation of the asset, regardless of the actual decline in value of the asset from year to year. For residential real estate, it has been determined that the asset can be depreciated over 27.5 years. Most apartment complexes fall in this category. Lets look at an example: You just bought a small apartment complex worth $1MM, does this mean that we can depreciate $1MM/27.5 yrs? Not quite, first we have to figure out how much of this is really depreciable; the land is not depreciable. Continuing with our example, the value of the building is only $700K. However, not all depreciation is created equal, there is straight line, accelerated depreciation, modified accelerated depreciation, and bonus depreciation. For our purposes we will deal with straight line and bonus depreciation.
Under straight line we would divide the depreciable part over the number of years ($ 700K/27.5yrs), and I would be allowed to approx. $36.4K of depreciation that I can write against my expenses on a year-on-year basis. As a passive investor, you are told that the general partner will do a cost segregation and apply for bonus depreciation, so what does this mean? As I mentioned, different assets can have different depreciable lives, and the IRS is keen to make sure you do this right. The general partner(s) will have to segregate or separate the different types of depreciable “parts” within the asset. If you are a syndicator, you must make sure to hire a professional to come and “segregate” the apartment complex into these different asset classes. Bonus depreciation is a form of accelerated depreciation. which allows you to take 100% of the accelerated benefit and utilize it all in year one of ownership. It's an amazing perk, but it will not last forever. In its current form, the full benefit lasts on properties acquired through the end of 2022. With bonus depreciation, instead of the $36.4K/yr, we would be able to depreciate a much larger amount, for this example and to keep things simple I will assume our full original $700K is depreciable on year 1, indeed, quite a perk.
Obviously, Uncle Sam always wants his money back, and just as we are allowed to depreciate, that depreciation must show up at some point. Unlike other assets that lose value through time, real estate actually appreciates. Continuing with our example, lets say that it is 5 years later and it is time to return their money to your investors. You did well and your apartment complex appreciated 60% and now is worth $1.6MM, your investors are anxious to get their profits and at the same time ask you if you know what the tax effects of the sale will be to them?
First you must understand your gain and separate this into its different components (let me explain). Recall you decided to take your depreciation benefit in the first year? Well, now your basis in the asset is $1MM (purchase price) - $0.7MM (depreciation) = $0.3MM. So your total gain is $1.6MM - $0.3MM = $1.3MM. So far so good, so… how will you be taxed on this amount? Capital gain? Ordinary income? Other? Yes, yes, and yes.
First the easy part, any gain above the purchase price will be taxed as section 1231 gain which gets taxed at capital gain rates (and since you held the asset for more than a year), this means long term or the more favorable capital gain rate. Your investor is in the 24% tax rate, which corresponds to a 15% capital gain rate. This means that $1.6MM-$1MM = $0.6MM will be taxed at 15%. What about the rest? The IRS assumes that you should have taken straight line depreciation or $36.4k/yr × 5yrs = $181.8K, and this is taxed at 25% as per regulations (regardless of your tax bracket). The excess above this (due to bonus depreciation) or $700K-$181.8K = $518.2K is taxed as ordinary income (24% in our example).
Now we can tell our investor that after we sell the asset, the total tax will be approximately $260K, and he/she should expect to receive his K-1 form that will lead to his proportional tax. At sale you will receive $600K of gain (minus closing costs and commissions), and if did not do anything else to get additional passive income, you would owe $260K in taxes. Not all is lost though, you can tell your investor that your next deal is right around the corner, and this may bring additional passive losses from more depreciation, hoping that by then the government has not taken away this huge perk that is bonus depreciation.
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