How To Use Taxes To Fund Your Next Investment
Tax shelters are always a popular topic for property investors. Everyone loves the idea of a good write off. For property owners, tax shelters are usually realized in the form of depreciation. In layman terms, depreciation is just an acceptance by the IRS that physical property deteriorates over time and begins to ‘lose’ value. According to the IRS, commercial multi-family properties have a lifespan of about 27.5 years.
Officially, the IRS defines depreciation as “a tax deduction that allows a taxpayer to recover the cost of a property over time. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.” It works like this; if you purchase a multi-unit property for $800,000, assume the depreciation is going to be 80% over its life, you are then granted a $640,000 depreciation schedule over the life of the property ( 27.5 years). So take $640,00 divided by 27.5 giving you a write off of approximate $23 thousand. This creates a tax shelter that can be used to offset income from the asset every year.
And you must use the depreciation shelter. If you don’t use it, the IRS automatically assumes you did when you sell the asset. Then you pay taxes on profit over the depreciation amount – even if you never received the depreciation benefit. This will cost you a 25% recapture tax, capital gains, and state income taxes. But here’s the rub; you may not really have to pay any of these taxes at all!
If you reinvest profits from the sale of an existing property into similar real estate, you can actually be tax-free at the end of the day. This is the “trade up” scenario and can create a haven for continued wealth building. But there are tricks to implementing this strategy. You must trade up in a specific time frame and hire a third party to handle the capital. You can then carry your cash forward to a new investment property. This strategy completely defers the recapture, capital gains, and state taxes. Essentially, it allows you to sell and re-invest without spending a penny to any tax authority. Fantastic, right?
So, what’s the catch? Well, there are a couple: The trade up property to replace your older retiring investment must be a similar kind of space. This is referred to as ‘like-kind,’ and the IRS defines it arbitrarily. Like-kind means similar in nature or character, excluding grade or quality. Like-kind property includes apartments, nearly all commercial categories, condos, duplexes, raw land, and rental homes. In other words, sell an apartment building, to get a tax-free trade up you must buy a similar apartment building – or close anyway. But the rules are liberal and can be argued.
Then there is the required QI, or Qualified Intermediary. A QI is a third party designated to hold on to the funds (escrow) which facilitate the trade up. This ensures the taxpayer does not spend the cash and avoids the taxes before reinvestment. A QI cannot be relative or go-between of an exchanging party. However, there are third-party services that facilitate this provision for you inexpensively.
The IRS also requires that once the sale of your existing property closes, you have 45 days to name a trade up site with the QI. So, finding one on your own and negotiating a sale is risky. In fact, investors can designate up to three potential properties – as long as you purchase one of them. You can even designate an unlimited number of trade up properties as long as the value of the replacement doesn’t exceed 200% of the all the trade up assets.
It is also important to note that whatever profits made on the sale of the existing property over the trade up purchase, they will be taxed. For example; If you sold your existing site for a $1 million, but your trade up is only $900,000, you have $100,000 of profit that will be taxed. Also, if you don’t receive cash back from the sale, but your liabilities are reduced, that too will be considered income. So, it pays for the trade up target asset be at the same value as the new property.
One common argument against the trade-up method is concerns over property taxes – or more specifically – incurring higher property taxes on the new asset acquisition. But this point is moot. The fact is that the interest deduction from the new loan and resetting of the newer higher depreciation schedule from the sale of the existing asset offsets a property tax increase. Often the tax deductions from the trade-up outweigh the tax bill on the new property. In our experience, the property tax gains have never been a factor in preventing a trade-up.
Now you may ask yourself how the new Trump tax plan will affect this strategy. In short, it won’t affect it at all. Although there were many tax loopholes cut in the GOP plan, this one was absent from the chopping block. Real estate industry groups, such as the Investment Program Association and Alternative & Direct Investment Securities Association, have been actively lobbying members of Congress over the last few years to save this program specifically.
At Mission CBI we can create a list of trade ups that meet or exceed the sale of your existing asset and advise of the best plan of action to fulfill the requirements needed for a pain-free transaction. We can then manage the new site for you or show you how to self-manage. Either way, you will realize consistent monthly cash-flow until it’s time to trade up again!