Do you use depreciation savings in your pro forma?

Question

Hey guys,

I have about 55 rentals but most are smaller units. Typically on my pro formas I don't figure in depreciation tax savings. I am pulling the trigger on a much larger complex, though, and the depreciation expense is substantial. I am in a very high tax bracket so taxes are costly. The annual tax savings would make a full 1+% cap rate difference.

Do you guys typically factor in depreciation tax savings when running the numbers on a large complex?

Matt K. · Answer

Thank you for this... the timeline is helpful.  This is actually one the biggest (and so far most expensive haha) lessons learned I've had because I was so nervous to refi after my 1031. I ended up getting taxed on a partial boot when I really could of just done the refi. This was mostly due to me not knowing enough about the 1031 to ask questions...

Dave Foster · Answer

@Matt Katsaris, it's a big issue if you're refinancing right before a sale and 1031.  The IRS has routinely attacked these.  And while there's no overabundance of case law I'd recommend trying to stay away from for the year before you sell unless you document circumstances, motivations, and justifications very thoroughly.

After the completion of a 1031 it's a different story.  A refinance immediately after a 1031 exchange of the new property is pretty common.  When done this way it perceived as "borrowing against equity" rather than a step transaction to access profit.  There are some who think a new wave of crack down on this type of activity might come but we haven't seen it yet.

Henry Perez · Answer

@Matt Katsaris I would ask the question why would one refinance right before selling his/her property through a 1031 exchange? It defeats the purpose of selling a property through a 1031 exchange when you just refinanced it.

You refinance your existing property in order to 1) keep your existing property because of its post-refinance cash flow (this will only work if the property provides positive cash flow after paying the monthly mortgage on the refinance), and 2) cash out the equity to purchase another property.

Thus, you will own two cash flow positive producing properties.

One sells through a 1031 exchange because 1) they have owned a property for a long period of time and it may not have many years left to receive the benefits of depreciation expense, 2) they want to sell their existing property for an even larger property

Both methods are great for scaling.

Henry Perez · Answer

As @Chase Gochnauer mentioned, depreciation won't come back to "bite you" if you plan on selling it through a 1031.

You have two options to avoid paying back the depreciation expense: 1) sell the building through a 1031 (this allows you to buy larger and larger properties each time without getting hit with capital gains tax or deprecation expense capture back, 2) refinance the property  and cash out your original equity (along with some or all of your appreciated equity you earned from the time of purchase) and use that cash to purchase another property.

I intend to use both options in order to achieve my goal of 1,000 units.

John Lenhart · Answer

@Chase Gochnauer when evaluating the deal to determine the price, I do not. When evaluating the deal for my own personal benefit I do. On the evaluation side, if you are looking for an 8 CAP your personal tax rate and savings are irrelevant. This will affect your own IRR and return on your cash, but it should not change the value of the property. The property is worth what it is worth whether you are in a 15% tax bracket or a 39% bracket

Matt K. · Answer

For me at least it was really the definition of what right before was... I had so many various timelines from overly cautious to overly optimistic. This was mostly through lots and lots of reading and searching online to try and understand the 1031. As far as why... I saw that some people had extremely low cost basis on something that was worth a significant amount. So for example they'd had cost basis of like 25k, it'd be worth 500k, they'd refi 200k prior to the 1031... The reason/logic I honestly can't remember or speak to it.

Henry Perez · Answer

@Matt Katsaris I hope I answered your question. If not, please let me know

Matt K. · Answer

How big of a concern is the “step transaction doctrine” (assuming one refis close to the exchange)?

Chase Gochnauer · Answer

Hey guys, thanks for the feedback. I Think we're on the same page. I shouldn't have said that it increases the cap by 1%, but just using that as an example to show how big of a difference it makes.

This will double my # of units, so just want to make sure my numbers are tight. Thanks!

Do you use depreciation savings in your pro forma?

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