Question to recaptured depreciation and capital gains tax

Multi-Family and Apartment Investing
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Question to recaptured depreciation and capital gains tax

Jered Collins
Johnson City, TN · Member since 2017 · 49 posts · 27 votes

Perhaps this subject has been discussed in depth before but I want to reinvigorate the importance of understanding the effects of recaptured depreciation and capital gains tax on sale of multifamily properties.  

I've done analysis on several multi-family dwellings around 20-30 units each. Both properties cash flowed well and had value-add opportunity. After doing a NPV comparison and IRR analysis on both properties the deals looked less appetizing upon the sale of the assets. I performed a 5 and 10 year analysis with the sale of the asset ending on year 5 and 10 accordingly. Strangely enough after year 5, I would yield a greater equity on the property after recaptured depreciation was inserted in the top line of the income statement. There are diminishing returns starting at year 4-5 on the model I built. I understand variables drive a large % of this (equity waterfalls, exit cap rates, etc.).

The point of all of this is to make people understand that if you have no intentions of 1031 exchanging or holding the asset until death you are subjecting yourself to a potentially heavy tax burden upon sale of the asset.  If fact in a lot of situations you actually pay back more tax upon the sale of the asset than the straight-line depreciation deductions all added up together. 

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Sam Grooms
Investor · Phoenix, AZ · Member since 2017 · 583 posts · 919 votes
7y
Originally posted by @Jered Collins:

Perhaps this subject has been discussed in depth before but I want to reinvigorate the importance of understanding the effects of recaptured depreciation and capital gains tax on sale of multifamily properties.  

I've done analysis on several multi-family dwellings around 20-30 units each. Both properties cash flowed well and had value-add opportunity. After doing a NPV comparison and IRR analysis on both properties the deals looked less appetizing upon the sale of the assets. I performed a 5 and 10 year analysis with the sale of the asset ending on year 5 and 10 accordingly. Strangely enough after year 5, I would yield a greater equity on the property after recaptured depreciation was inserted in the top line of the income statement. There are diminishing returns starting at year 4-5 on the model I built. I understand variables drive a large % of this (equity waterfalls, exit cap rates, etc.).

The point of all of this is to make people understand that if you have no intentions of 1031 exchanging or holding the asset until death you are subjecting yourself to a potentially heavy tax burden upon sale of the asset.  If fact in a lot of situations you actually pay back more tax upon the sale of the asset than the straight-line depreciation deductions all added up together. 

Can you explain your last sentence? 

Also, you can't just add depreciation recapture to the top line of your income statement. It gets taxed at a different rate. Taking the depreciation is about two things. 

First, moving up expenses, which is almost always a good thing. Yes, you'll "pay it back" on the exit through recapture, but if someone says I'll give you money today, and you have to pay it back at a future date with no interest, most people will take that. 

Second, it's about tax rate arbitrage. Depreciation is shielding your income from being taxed at your ordinary income tax rate, up to 37%. When you recapture it, it gets maxed out at 25%. 

So in summary, not only do you get to wait years, possibly decades to pay taxes on that income, you can possibly pay the taxes at a lower rate. For most people, this makes sense. Yes, if you buy in an area that doesn't appreciate, its possible your tax burden on exit is greater than your gain, meaning you lose money in that year. But, overall, you're still better off, as long as you plan accordingly. 

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  • Sam Grooms
    Investor · Phoenix, AZ · Member since 2017 · 583 posts · 919 votes
    7y
    Originally posted by @Jered Collins:

    Perhaps this subject has been discussed in depth before but I want to reinvigorate the importance of understanding the effects of recaptured depreciation and capital gains tax on sale of multifamily properties.  

    I've done analysis on several multi-family dwellings around 20-30 units each. Both properties cash flowed well and had value-add opportunity. After doing a NPV comparison and IRR analysis on both properties the deals looked less appetizing upon the sale of the assets. I performed a 5 and 10 year analysis with the sale of the asset ending on year 5 and 10 accordingly. Strangely enough after year 5, I would yield a greater equity on the property after recaptured depreciation was inserted in the top line of the income statement. There are diminishing returns starting at year 4-5 on the model I built. I understand variables drive a large % of this (equity waterfalls, exit cap rates, etc.).

    The point of all of this is to make people understand that if you have no intentions of 1031 exchanging or holding the asset until death you are subjecting yourself to a potentially heavy tax burden upon sale of the asset.  If fact in a lot of situations you actually pay back more tax upon the sale of the asset than the straight-line depreciation deductions all added up together. 

    Can you explain your last sentence? 

    Also, you can't just add depreciation recapture to the top line of your income statement. It gets taxed at a different rate. Taking the depreciation is about two things. 

    First, moving up expenses, which is almost always a good thing. Yes, you'll "pay it back" on the exit through recapture, but if someone says I'll give you money today, and you have to pay it back at a future date with no interest, most people will take that. 

    Second, it's about tax rate arbitrage. Depreciation is shielding your income from being taxed at your ordinary income tax rate, up to 37%. When you recapture it, it gets maxed out at 25%. 

    So in summary, not only do you get to wait years, possibly decades to pay taxes on that income, you can possibly pay the taxes at a lower rate. For most people, this makes sense. Yes, if you buy in an area that doesn't appreciate, its possible your tax burden on exit is greater than your gain, meaning you lose money in that year. But, overall, you're still better off, as long as you plan accordingly. 

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  • Jered Collins
    OP
    Johnson City, TN · Member since 2017 · 49 posts · 27 votes
    7y
    @sam grooms Here is a simplified example of how the recaptured depreciation can outweigh the annual benefits of depreciation Here is an example: Let’s say you had a house that had a house value (not land) of $100,000 when you put it into service as a rental. You’d take about $3,600 in depreciation each year. If you are in the 15% tax bracket, you’ll pay $540 less in taxes each year due to depreciation. After five years, you sell the house for more than you paid. In calculating the taxes on the sale, you’ll take the $18,000 you’ve taken in depreciation, and pay $4,500 in recaptured depreciation taxes on the sale. (Again, this is the extremely simplified explanation of the math. It’s actually much more complicated.) You pay $4,500 in recaptured depreciation taxes even though you only benefited by $2,700 in taxes during the years you were depreciating.
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  • Sam Grooms
    Investor · Phoenix, AZ · Member since 2017 · 583 posts · 919 votes
    7y
    Originally posted by @Jered Collins:

    @sam grooms Here is a simplified example of how the recaptured depreciation can outweigh the annual benefits of depreciation

    Here is an example: Let’s say you had a house that had a house value (not land) of $100,000 when you put it into service as a rental. You’d take about $3,600 in depreciation each year. If you are in the 15% tax bracket, you’ll pay $540 less in taxes each year due to depreciation.
    After five years, you sell the house for more than you paid. In calculating the taxes on the sale, you’ll take the $18,000 you’ve taken in depreciation, and pay $4,500 in recaptured depreciation taxes on the sale. (Again, this is the extremely simplified explanation of the math. It’s actually much more complicated.) You pay $4,500 in recaptured depreciation taxes even though you only benefited by $2,700 in taxes during the years you were depreciating.

    Yes, if you are in a very low tax bracket, avoiding taxes at 15% to pay them at 25% might not make sense. However, if I can make a 20% annual return on my investments, well then I'd still be better off with the extra cash today, and paying it back at a higher rate in the future. 

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  • Jered Collins
    OP
    Johnson City, TN · Member since 2017 · 49 posts · 27 votes
    7y
    Originally posted by @Sam Grooms:
    Originally posted by @Jered Collins:

    @sam grooms Here is a simplified example of how the recaptured depreciation can outweigh the annual benefits of depreciation

    Here is an example: Let’s say you had a house that had a house value (not land) of $100,000 when you put it into service as a rental. You’d take about $3,600 in depreciation each year. If you are in the 15% tax bracket, you’ll pay $540 less in taxes each year due to depreciation.
    After five years, you sell the house for more than you paid. In calculating the taxes on the sale, you’ll take the $18,000 you’ve taken in depreciation, and pay $4,500 in recaptured depreciation taxes on the sale. (Again, this is the extremely simplified explanation of the math. It’s actually much more complicated.) You pay $4,500 in recaptured depreciation taxes even though you only benefited by $2,700 in taxes during the years you were depreciating.

    Yes, if you are in a very low tax bracket, avoiding taxes at 15% to pay them at 25% might not make sense. However, if I can make a 20% annual return on my investments, well then I'd still be better off with the extra cash today, and paying it back at a higher rate in the future. 

    You are correct. The more I think about this subject the more I want to test the idea of diminishing returns due to recaptured depreciation and capital gains. Basically there is a sweet spot for IRR.

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  • Sam Grooms
    Investor · Phoenix, AZ · Member since 2017 · 583 posts · 919 votes
    7y

    I think it has more to do with the individual investor's tax situation. How much other income do they have that can be offset by the depreciation? Are they a real estate professional? What's their tax rate before and after the depreciation? Yes, they may have a 15% tax rate after the depreciation (because they have hardly any income now), but if their tax rate was 25%+ before taking all of that depreciation, well then you have to consider that as tax savings. 

    Then, if they end up in a situation like what you mentioned above ($4.5K vs $2.7K), what type of investments are they putting their tax savings from years 1-5 in? 

    2Reply
  • Basit SiddiqiBusiness Member
    Accountant · New York, NY · Member since 2015 · 8k+ posts · 3k+ votes
    7y

    I am not sure I follow the logic here.

    Depreciation expense is great in that it is a non-cash tax expense in the year of the deduction.
    If the taxpayer is in the top bracket of 37%, he is getting a savings of 37%.
    Now if he decides to sell the property and gets his with depreciation recapture, it is capped at 25%

    Granted - this scenario is assuming the taxpayer is in the top bracket. The greater the bracket of the taxpayer, the greater the spread for the difference of depreciation and depreciation recapture.

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  • Jered Collins
    OP
    Johnson City, TN · Member since 2017 · 49 posts · 27 votes
    7y
    Originally posted by @Basit Siddiqi:

    I am not sure I follow the logic here.

    Depreciation expense is great in that it is a non-cash tax expense in the year of the deduction.
    If the taxpayer is in the top bracket of 37%, he is getting a savings of 37%.
    Now if he decides to sell the property and gets his with depreciation recapture, it is capped at 25%

    Granted - this scenario is assuming the taxpayer is in the top bracket. The greater the bracket of the taxpayer, the greater the spread for the difference of depreciation and depreciation recapture.

     I’m in the opposite spectrum or your scenario. 

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