Question to recaptured depreciation and capital gains tax

[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. 

[Sam Grooms]

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.