Depreciation, 1031 Exchange, Long Term Capital Gains

Over the next few articles, we’re going to briefly explain why real estate is a truly tax-advantaged asset class. First, we’ll talk depreciation.

As time goes on, history has shown real estate overall as an asset class goes up in price.
But one of the great advantages of investment real estate is the ability to depreciate an “appreciating asset.”
While we can’t depreciate the land component of a piece of real estate, the improvements and structures on the land are fair game.
Apartments are depreciated over 27.5 years, and other commercial assets over 39 years.

This means that we are allowed to “write off” 3.63% or 2.56% respectively of the value of our structure each year. This may not seem like much, but when combined with the leverage many investors utilize when acquiring real estate, the depreciation write-offs can create a nice tax shield.
The IRS is not stupid though. When you sell your asset that has been depreciated, you’ll ultimately realize a gain on the sale price versus your depreciated cost basis, so there isn’t really a truly free lunch…or is there?
More on deferring capital gains on your property sales next time.

I talked about how the depreciation write-offs can be an effective way to shield your tax-advantaged rental income from your investment real estate even further. The problem with this strategy comes along when you have to sell, and your cost basis is way below your sales price. This can mean a big tax bill. So what do you do?

You execute what is known as a 1031 exchange. I won’t get into the nitty-gritty details of how to stay compliant in the IRS’ eyes, but the premise is actually simple. The tax man will allow you to defer your capital gains into the future if you “trade” or “exchange” your asset for another one of “like-kind.” What this allows you to do is to sell your property, and quickly purchase another one, all the while incurring no capital gains.

For instance, you have a cost basis of $1 million dollars in a property that you find a buyer for at a price of $5 million. Instead of having a $4 million dollar capital gain and paying a big chunk in taxes, you can unload your $5 million property and “immediately” purchase a different asset all the while deferring your $4 million capital gain into your next property. You’ll now have a $1 million cost basis in your new asset.

The theory is to continue to execute profitable deals and roll into larger ones all the while deferring taxes into eternity. Eventually, you will die, and your heirs will take over with a stepped-up basis. What’s really special is that the income you’ll receive from the larger asset is not affected in any shape, manner, or form.

I talked about how savvy commercial real estate investors utilize 1031 exchanges to “trade-up” properties to defer capital gains taxes and how they depreciate “appreciating” assets. These are some of the major tax benefits we can take advantage of opportunistic real estate investors. The other big tax advantage associated with owning rental property is the treatment of capital gains when we sell a property.

After holding property for one year, the capital gain from a sale of real estate in the US is currently subject to long term capital gains treatment. This is typically less from a percentage standpoint than our corresponding “ordinary income” tax brackets.

Our income is also considered passive income, which provides certain benefits compared to ordinary income as well.

By purchasing real estate, you are also able to convert ordinary earned income into passive income which can add up to savings over the course of time.